The choice between debt or equity is an age-old question for companies looking to grow. Both represent forms of capital, which can in turn provide the funding required for a company to execute on its growth plans. The choice between debt and equity funding can however make a significant difference to eventual business outcomes. As such, it’s imperative that the company chooses the best path forward.
What’s the Difference?
The most basic form of debt is a loan, where one person, or entity, lends money to another. Attached to this loan are terms, including a principal, interest and maturity date. The principal is the original amount that was borrowed, the interest rate is the percentage of that amount that needs to be paid each period, and the maturity date is when the principal needs to be repaid. There are an infinite number of variations on how a debt instrument is structured, but almost all of us will touch debt in one form or another, such as a credit card, mortgage, or bank loan.
Equity in its simplest form represents ownership in a company. When you buy shares in Telstra on the ASX, you are buying part of the company’s equity. Companies can raise funds by issuing new shares, or selling existing shares, in exchange for cash or other consideration. When an investor buys equity, they are entitled to a number of rights alongside other shareholders, such as a share of profit distributions, voting rights and more. They can also sell their shares at a later date for a capital gain if the value of the company increases. The key difference between debt and equity is that a company must repay its debt at the maturity date. On the other hand, funds raised through selling shares is the company’s to keep.
For larger, more mature companies, debt generally far outweighs equity in terms of benefits. This is partly known as the debt tax shield benefit where leveraging through debt can allow a company to enjoy additional tax benefits alongside company growth. Furthermore, larger more stable companies are able to take on more debt and better rates, since banks can be more assured of their ability to pay back any loans. Large companies will still raise capital through equity, especially during difficult periods or when a large amount of funding is required. In this article, we’ll focus on the choice for earlier stage companies.
Debt often has a taboo surrounding it given all the horror stories. There is definitely a level of risk attached to debt, but equally the benefits of leverage to accelerate growth are large. The main consideration with debt is if the company is in a suitable position. Some businesses are lucky to have shareholders or directors who can make interest-free loans, meaning the company can take its time to pay them back until it's in a position to do so.
For others though, the range of debt available to early stage businesses is limited. Most banks will steer away unless the debt can be secured by an asset such as a piece of machinery or land. Some will also let the debt be secured against the wealth of a director, but this presents potential downside should the company fail to meet its objectives. At an early stage, many debt providers will also require strict terms with high interest rates that can derail a business when things don’t go exactly as planned.
For businesses that are pre-revenue or pre-profit, debt is generally extremely risky and can upend not only the company, but people’s livelihoods. As a general principle, only borrow what you are certain you can repay, even if things don’t go to plan. If there’s one certainty in the start-up world, it’s that things never turn out exactly how you think they will!
Many founders stray away from equity financing because it means giving part of your business away. Be that as it may, a smaller slice of a large pie is worth a lot more than a large slice of no pie!
For most early stage ventures, equity financing is the only viable option until the business has reached a level of stability and profitability. The other key benefit of equity is that you don’t need to pay it back, or pay interest, meaning you are free to use the cash to grow aggressively without worrying about an impending due date.
Bringing on shareholders can also have its benefits, such as strategic investors who can help steer the business in the right direction, or an army of brand advocates that can be achieved through equity crowdfunding with Equitise.
An important consideration is not raising more than you need at any given point, as this would mean giving away more equity than necessary, which can reduce your control and stake in the business down the line.
There are also other types of funding instruments out there. Hybrid securities, such as convertible notes, are a combination of debt and equity that can be particularly useful for certain companies in certain situations. Equitise facilitates raises for alternative instruments through our wholesale offers, but we can only raise via ordinary shares for equity crowdfunding opportunities.