Factors to Consider When Choosing Between Debt or Equity Funding
Businesses with low overhead and strong cash flows may be better off with debt financing.
Various institutional investors, Hedge Funds, Private equity firms, etc. Have, over the last ten or so years, poured billions of dollars of equity funding into startups around the world. According to the PitchBook-NVCA Venture Monitor, VC firms invested a total of $84.2 billion last year, up 16 percent from 2016 and more than 100 percent from ten years ago. With most firms seeking out startup firms with valuations above $1 billion: the so-called Unicorns.
It seems like every time you crack open your favorite financial publication, turn on the TV or read the news, there a lot of talk of entrepreneurs who have raised millions of dollars in VC funding. As an entrepreneur, you may be thinking about seeking out funding for your business as well. After all, why wouldn't you want to become an instant millionaire after all the hard work you have put into building your business.
Understanding Debt vs. Equity Financing
You should know, that, as sexy as the idea of raising boatloads of cash may be, this type of funding may not be appropriate for your type of business, or where you are in your growth story.
Sometimes, you may be better off looking for debt financing. You know, a low-interest rate loan that would not require you to give up equity in your business, or have to endure the hassle of dealing with professional investors just yet.
Whether equity funding or debt financing is right for you is a question that you and only you can answer. I will, however, suggest some basic question you should ask yourself to help get a better picture of which option may be right for you.
Do you have strong cash flow?
This point is paramount to helping you decide what type of financing to go for. Do you take in cash, pay your overhead costs and still have a healthy chunk left after adjustments for taxes are made? If you don't, don't worry. Most growing businesses do not. However, if that is the case, then you can see how making regular payments on a loan with 20% on top might be a bit of an issue. Here, you might need to give up some equity to access financing or seek out Angel investors who might be a bit more understanding of your situation and thus structure a deal that may be a bit more flexible.
How fast are you growing?
Most small businesses, especially in the tech and renewable energy sectors usually grow very fast. The average tech outfit, five years or less old, will see an average annual growth rate of 60, percent according to Mckinsey & Co.
Higher growth rates signal long-term viability of your company, especially if the growth you are seeing comes without giving up much on the net profit side of things or without significant increases in marketing spend.
So how does this help you determine what type of funding to go for? Well, look at it this way: If you are growing fast, top and bottom, then, you might find yourself in a price volatility situation and might end up undervaluing your company to get equity funding.
Here, a small loan, with low interest and favorable terms might be a better option. So you can save yourself the hassle of haggling over price-to-equity figures with VC's.
What's your expense structure?
Here is an easy one: Are your expenses growing or decreasing as it relates to your ROI? In other words, are you being efficient with your dollars? Do you plan to improve the quality of your expense structure? Do you have a bloated capital infrastructure? These are very important factors to consider.
If you spent the same amount of marketing, payroll, and R&D dollars in two consecutive years, with all things being equal, and saw a decrease in revenue in the later year(s). Then you might need to restructure your spending models. You might have to fire some of your employees, terminate some short-term contracts, etc. Doing this will help streamline your business and help attract quality loan or investment offers.