Jackson Ross PLLC

What is the Difference Between Debt Financing and Equity Financing?

Startups looking to grow and expand their business enterprises often look to outside investors for growth funding. Where fueling the growth of a business on profits alone is not feasible, startups have a few primary options when it comes to seeking outside funding: debt financing, equity financing, or debt-equity financing. Each funding option carries its own advantages and disadvantages, but all require legal documentation detailing the terms of the arrangement between the startup and the investor. If you are a startup founder who needs advice about the different financing options you have or assistance with securing growth funding, you should contact a business lawyer who is licensed in or familiar with your company’s jurisdiction of incorporation.

 

Debt Financing

Debt financing involves taking on debt in exchange for capital, i.e. borrowing money. This means taking a loan, which in turn means that the startup will have to repay the amount borrowed, as well as pay an interest rate, to the debt holder. Debt financing can be obtained from banks, lenders, governments, family, friends, and private investors – basically anyone or any institution that is willing to give you a loan.

When choosing debt financing for your startup, the startup and the investor will hammer out the details of the loan and enter into a debt financing agreement (i.e. a loan agreement). Borrowing money to finance growth can be risky since the debt will need to be repaid even if the startup does not succeed, and oftentimes repayment of principal or payment of interest is required at set intervals (i.e., monthly, bimonthly, quarterly, etc.), which may not come at convenient times for the startup. Failing to make repayments or interest-only payments on time can lead to serious consequences for the startup. The loan will default, and then you’ll be in more trouble than Kim Kardashian at a talent show.

Despite having to repay the amount borrowed plus interest, many startups find debt financing to be a desirable form of financing, since debt financing allows the startup founders to retain control of their company and to get their hands on money immediately. Debt financing only involves money – an amount lent and an amount to be repaid. No equity share in the startup company, i.e. ownership, must be forfeited in exchange for the growth capital.

 

Equity Financing

Equity financing, on the other hand, involves the exchange of an ownership stake in the startup company for some set amount of capital. This is done through the issuance of shares. In effect, a portion of control over the company is sold to an investor for a set price. There is no repayment of principal or payment of interest to a lender in an equity financing arrangement.

Equity financing is an attractive financing option since it is a complete transaction in its own right, i.e. the startup does not have to worry about repaying the investor for the money that is received through the equity financing agreement (at least until a liquidation event), nor does the startup have to worry about paying monthly loan obligations. However, issuing additional shares of stock in the startup company depletes the previous shareholders and founder’s stake in the company and entitles the shareholders to a cut of the startup’s profits. Some of these issues can be mitigated depending on the type of security that is being issued and the terms of the offering.

When startups are considering using equity financing to pay for the growth of their business, they should work closely with an experienced business lawyer to develop an equity plan that is right for their business strategy. Your lawyer can also help you prepare the primary and any ancillary equity financing agreements.

 

Convertible Debt Financing

Debt financing and equity financing do not necessarily have to exist as independent and separate options that are mutually exclusive. Some investors are interested in convertible debt financing arrangements. Convertible debt financing is a blend of debt financing and equity financing, in which the two financing options coexist. These arrangements often feature the issuance of a security, such as a convertible promissory note, that is treated as a loan upfront but can be converted into equity at the option of the holder or when certain benchmarks are reached (qualified financing, change of control, and IPO being the most common).

For example, a convertible debt financing arrangement might involve an investment of one hundred thousand dollars in the form of a convertible promissory note to be repaid over two years at an interest rate of six percent. However, if the startup experiences solid growth and secures a qualified financing of $1 million before the convertible note principal falls due, the note can be converted, at the investor’s option, into equity in the startup. This arrangement would:

  1. Eliminate the remaining portion of the loan, freeing up capital for the startup;
  2. Align the investor’s goals with those of the startup, i.e. to scale and achieve its milestones; and
  3. Obviate the need to determine the value of the startup’s shares up front, unlike traditional equity financings.

When it comes to obtaining financing for startups, there are many options that are available. What works best for your particular startup is something that you will need to carefully consider. An experienced emerging companies and venture capital lawyer who is licensed in or familiar your startup’s jurisdiction of incorporation could help you and your startup develop a financing strategy that works for you.