Debt versus Equity

Before you begin to hunt for capital, it is important to know the kind of capital you need and when and why you need it. There are basically two capital pool types. The first is debt; the second is equity.

 Debt Capital

Debt capital is probably most familiar to entrepreneurs, as debt is often what we know about in personal life.  Bank loans for cars or mortgages on houses, and the use of credit cards for the purchase of personal items, are common debt instruments.

Debt financing for a company is very similar. A lender, be it a bank or individual, will loan money to an entrepreneur with the agreement that it must be paid back with interest over a period of time. As a means of reducing risk, the lender will want to have collateral of sufficient value to cover the amount being granted, in case the company is unable to pay back the loan.

However, for a start-up company, using debt to raise capital is not an option.  Why? Because the company does not have any assets to pledge as collateral; nor does it have any revenues with which to pay off a debt. In such instances, some lenders may insist the entrepreneur pledge their personal assets as secured collateral. Of course, this would only occur if the lender is confident in the business, and the entrepreneur is equally confident in the company’s prospects to pay down the debt.

It is not uncommon for the entrepreneur to use credit card debt to finance a company’s growth, particularly in the early stages. However, in many cases these credit cards are personal debt instruments with their associated high interest rates, and they hold additional personal risks for the entrepreneur. Running up a high personal credit card debt, with no income on the horizon, can keep an entrepreneur awake at night with worry.

 Equity Capital

The second capital pool is equity. This, principally, relates to the sale of the company’s shares in exchange for cash from an investor.

Other people’s money

 Arguably, equity as a financing option seems preferable to going into debt. You don’t have to use your first-born as collateral (something you might want to do if you have a teenager), and fret over whether you can make monthly payments. But having said this, there are issues that have to be addressed, because when you exchange equity for cash you will be “using other people’s money.” When you receive funds from an independent third party in exchange for equity in your company, immediate expectations and obligations are triggered.

To begin with, equity investors own a part of the company. Through the purchase of shares they essentially become new partners. They expect higher returns for the risks they are taking by investing in the company than they would by placing their money into safer and conservative investment instruments. These investors have a “vested” interest in your success because they have contributed their own money toward it.  As a result, you are accountable for how wisely you spend their money.

 

An equity investor can be involved with your company for a long time, since a liquidity or exit event such as an acquisition or IPO (Initial Public Offering) might take five to seven years to happen, if it happens at all.  Early-stage companies are risky ventures. Therefore, keeping long term investors on side during the good, the bad, and yes, the ugly times in your company’s development is a good idea. Why? – Because you may have to go back to them again if more capital is needed.

Smart money

 Private equity investors can provide more than just money to satisfy your cash-thirsty enterprise. In some cases, they can offer solid business advice. This is particularly true if the investor is familiar with your industry. Private equity investors are also “channels to capital” and expand your reach to other investors by virtue of their existing business networks.

If your “lead” investor likes your company and shares this with others, good news travels fast and can be infectious. Don’t underestimate private equity investors, as they bring more than money to the table. They bring their experience and contacts as well.

 Investor expectations

 What do equity investors want to see before they invest in a company? The answer is simple – they look for companies that have the ability to increase enterprise value over time. This means that at exit or liquidity the investor expects to make 10 to 100+ times his or her original investment.  How you as the entrepreneur strategically spend the capital raised in each round must increase share value.  Investors want to see their shares become more valuable over time, as this translates into a return on investment – a win for you and a win for them.

If your company’s shares do not appreciate in value, the future prospects of raising additional capital will most certainly diminish. To coin a phrase “companies don’t fail; they just run out of money.” To avoid this unfortunate situation, you must create a financing strategy that increases share value and, therefore, the overall value of your company.

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