One of the investors in my company described equity as “fuel” for growth and debt as a “retardant” to growth.
I don’t think I agree with him. I think the right answer is more about what’s right for you and your company.
There is a better way to look at what’s right for you. I’ll get back to this later. First, let’s look at equity and debt.
There are obvious pros and cons to equity and debt:
- The biggest pro for equity is you don’t have any interest to pay and there is no collateral required, but…
- The biggest con is you give up a piece of your company
- The biggest pro is you don’t have to give up any equity to get your money, but…
- The biggest con is you have to pay back the interest and the principle, so your burn rate goes up
Whether you give equity or get a loan for your money, you now have to answer to somebody:
It’s true that if you get a loan your lender is not likely to be on your board of directors. However, you will have to give your lender updates on how your company is doing. And you’ll have to pitch your prospective lenders just like you’ll have to pitch prospective investors.
The better way to look at how to finance your company.
You always have investors regardless of whether you self finance the company, get equity, or get a loan. The key to a successful relationship with the people that finance your company is alignment.
You and your investors need to be in alignment for the goals and outcome for your company.
There are many companies that just don’t fit an equity or venture financing model. The question you need to ask is “What are the expectations of my investors?”
Let’s go through them one by one:
A. Venture financing.
Professional investors are expecting a multiple on their money. For early stage VCs, this number is 10X or more.
Let’s say you raise $5M and you give up 30% of your company in return. This means your investors expect at least $50M on their money.
But, your company has to be worth $167M for your investors to be happy. The questions you need to ask are:
a. How am I going to make my investors liquid?
In other words, you are either going to need to sell the company or have an IPO. Are these outcomes realistic in your situation, and are these outcomes something you want?
Only pursue VC financing if the answer is yes.
b. Will a successful exit for my company “move the needle” for the VC fund?
A $50M exit is a fantastic result for a smallish VC fund of $50M or $100M, but is a yawner for a $1B fund because the result will not meaningfully effect the outcome for the fund.
You need to be right sized for the fund you are taking money from. In most cases, VCs will just say no if your company isn’t the right size for the fund, but you will have problems later if you somehow get money from a large fund whose expectations are different than yours.
B. Angel financing.
This is pretty similar to venture financing, and it covers the $500K scenario as this is probably too small for most venture funds.
Again, the question comes down to how are you going to make your investors liquid?
Angels probably expect an even higher return than VCs because they are taking more risk. I would use a 30X return for planning purposes.
So let’s say you give up 20% of your company in exchange for your $500K. Your investors are expecting a return of $15M.
That means your company will need to worth $75M for them to successfully exit. But what if you need even more money to get to cash flow positive? Then the numbers go up.
What do lenders care about? They want to make sure you pay the interest and the principle back.
Remember that banks need collateral for your loan. What is it going to be? If you don’t have collateral, then you’re likely not going to get a loan. And that’s a big challenge for an early stage startup.
Finally, you have to work into your financial plan the payback of the interest and the principle. Your runway will be less when you take a loan, so that’s the big tradeoff.
Most entrepreneurs underestimate the downside of having a reduced runway! You shouldn’t.
Running out of money ahead of schedule kills a lot of companies. Sometimes you can get your bank to work with you to suspend principle payments in times of need.
However, their generosity does not come for free. You’ll have to give up something (usually a larger payment later) in return. And, when you’re back is against the wall, your room to negotiate is small.
Some banks will not negotiate with you at all. If you miss a payment, they’ll pull the loan. Do your research to see how startup friendly the bank you intend to work with is.
D. Friends, Family and Yourself.
Maybe you can afford to self-fund the company for $500K. You still have an investor in this case and you need to be in alignment.
Talk to your spouse or your family and make sure they understand how quickly the loan will be repaid. The oversight when you take money from these sources is less, but they still need to understand when they will get paid back.
For more, read: Five Reasons Why You Should Avoid Raising Venture Capital