Growing your startup takes grit, determination, and capital. That said, it’s important to understand your options when it comes to financing your business. You’ve likely heard of debt financing and equity financing. But what do these financing options entail? What will choosing one or the other mean for your business growth?
What is Debt Financing?
Debt financing is the process of obtaining financial support from that of a lender with the expectation the debt will be repaid after a designated period of time. As with any typical loan, lenders will set an interest rate for which the creditor will be required to owe on the money borrowed.
A recent article from the U.S. Chamber of Commerce reports while “the total cost of venture debt may seem expensive, it is typically only 25% to 50% of the cost of equity.” Which is why it’s no surprise that startups are favoring debt financing more than ever.
The Benefits
Debt financing comes with many business benefits, such as having upfront information on the terms of the loan. Thus, you can rest assured that no sneaky debt obligations will come out of the woodwork unexpectedly. Not to mention, any interest your business pays on the loan is tax deductible. Sounds great so far, right?
Well, the main benefit of debt financing is that it doesn’t require you to give up equity in your business. That also means the lender doesn’t have the ability to claim future profits. So you’d acquire financing for your business and your business remains yours.
Additional benefits include:
- Greater flexibility to fund a variety of needs to handle unforeseen growth or circumstances.
- The due diligence process is more straightforward, on average, than that of equity financing.
- Pre-agreed interest rates limit the cost of the debt.
The Drawbacks
There are a few negatives to debt financing, but none should come as a shock. For starters, the debt needs to be repaid, of course. Besides that, initially qualifying for a loan could be challenging if your business’ credit score and overall financial condition are poor. And lastly, if the debt isn’t repaid during the allotted time, the bank may have full authority to seize your assets.
However, if your startup is in good financial standing, has great credit, and is prepared to pay back its debts, debt financing could be a great solution for you. Here’s what Tosin Adesegha, former Vice President of Finance at Pathstream, had to say about working with 5th Line to secure debt financing:
“5th Line was a real value-add to raising our venture debt financing. We did not have a lot of experience among the team or the board with alternative sources of capital and [5th Line] was a great guide through the process. In the end, we couldn't have asked for a better partner and facility to help us scale and would never have achieved this outcome without [5th Line’s] help.”
What is Equity Financing?
Equity financing is described by The Economic Times as “a method of raising funds to meet liquidity needs of an organization by selling a company's stock in exchange for cash.” In short, equity financing requires business leaders to give up a piece of ownership in their company to receive the capital necessary to grow their business.
SIFMA found that “As of November 2023, the total equity issuance amounted to $129.5 billion, marking an increase of 39.1% compared to the previous year.”
The Benefits
It’s possible to receive a greater sum of money from the right investor through equity financing rather than debt financing. The best part? The money doesn’t have to be returned even if your business fails.
Additional benefits include:
- You are not obligated to pay dividends on equity.
- You’ll likely gain greater exposure and connections by working with the right investors.
- Venture capital is accessible at earlier stages for businesses, giving them the operational flexibility needed to succeed in a rapidly growing and competitive space.
The Drawbacks
Notably, the biggest drawback of equity financing is giving up a portion of your stake in the business to an investor. This means you might have to give up some control over your business to the investors. Doing so may take your business off in a different direction than you had intended (for better or for worse).
Another con to equity financing is that attracting investors, securing time for them to listen to your pitch, and actually closing the deal is more challenging than getting a loan. Often, getting an investor onboard with the terms of an agreement can take just as long, if not longer, than finding an investor willing to listen to your pitch in the first place.
Debt Financing vs. Equity Financing: When Does It Make Sense To Raise Either?
Both financing options have their pros and cons, as discussed above. But is there a better time to commit to one rather than the other? It all depends on the stage of your startup:
Equity financing is often best leveraged at the Seed Stage, Startup Stage, First Stage, and Expansion Stage of a new business. This type of financing gives early-stage startups an accessible way to acquire an active investment in the permanent capital of the company.
While early-stage startups also use debt financing, it’s most often leveraged by companies that have strong revenue performances over a longer period of time, typically backed by a proven base of customers.
Final Thoughts
If you’re still unsure of which financing route is right for you or if you’re struggling to find lenders to raise funds, you’ve come to the right place.
At 5th Line Capital, we’re experts in raising non-dilutive capital for growth-stage companies looking to avoid equity dilution. We also specialize in guiding growth-stage companies through the intricate landscape of financial operations, leveraging our team's cumulative expertise of over 50 years across diverse sectors of technology and services.
Let us help you scale your business. Get in touch with us to get started.