Understanding the Key Differences between Equity Financing and Debt Financing
So your tech startup is blessed with brilliant technology, a tight go-to-market plan and a skilled management team to execute. Even so, at some point your company will need outside financing - maybe to grow your sales department, or acquire a complimentary product, or for any other strategic or operational initiative. One Stop Capital can help with this important process.
The growth of any venture can be accelerated in many ways but almost always requires raising money from outside sources. However, it's important for every entrepreneur to understand the two primary types of financing that their company can receive and the many variations and attributes of each type. A business can choose, a) debt financing b) equity financing or, c) a combination of both in a single transaction.
Despite the common notion that taking on debt is detrimental, borrowing money for one's business can be a healthy way to grow in the short term as well as long term for any business. If an entrepreneur can secure debt financing on reasonable terms for a creditor, they can accelerate revenue growth to a point where this debt can be repaid quickly and without the dilution of ownership. After the debt is refinanced or repaid, the trending of a company's revenues and profitability can greatly exceed what they would have been without the loan. Obviously, a desirable outcome and attractive option. In addition to this, there are other benefits of debt financing that should be explored while building an ideal investment structure for your business including:
Tax benefits - using debt to finance your company often comes with significant tax benefits for bother the lender as well as the borrower and not only in the current time period but also well into the future. This is an important but often overlooked benefit in many transactions.
Variable interest rates - financing terms that include changing interest rates must be reviewed and negotiated. With many loans, your repayment timeline is subject to change along with shifting conditions applied to such changes. All potential outcomes should be considered, and this requires a thorough amount of due diligence being performed.
Convertible notes - this form of debt financing converts to straight equity or warrants to purchase equity under certain conditions, for example, if a company achieves certain financial or sales targets. Convertible notes are increasingly popular for earlier stage funding and especially when partnering with smaller investors since it is mutually beneficial to both parties. Company management is motivated to strive and reach these targets while creditors become more committed to the long-term growth of their investment company. Ultimately, the initial investment becomes a higher return on investment.
Any transaction where an investor exchanges cash or similar capital for an ownership stake in the company is known as equity financing. Unlike debt, equity investment terms typically do NOT include the repayment of the invested amount. However, terms can sometime include royalty payments, fixed or variable dividends, and other structured payments as well as initial fees for due diligence and upfront costs.
There are multiple factors that determine which investor is most suitable or interested in funding your tech company. Factors such as your industry or subsector, size of investment, stage of financing, life cycle of company, investor's specialization and ability for due diligence, geographic location, risk profile, market timing and others. The different types of equity investors include:
Angel Investors - Crowd Funding Platforms - Venture Capital - Family Offices - Private Equity - Special Acquisition - M&A outfits - Public Offerings or IPO's
Pros of equity financing - as mentioned, exchanging company equity for an investors cash also leads to that investor being incented to advance the long-term prospects of company. A healthy company poised for long term growth translates to higher enterprise values to the benefit of both parties. Another advantage of equity versus debt financing is the absence of any fixed repayment terms and the accompanying budgeting and cash flow issues. The management of this business isn't distracted about large upcoming payments and can focus on allocating their funds to stimulating company growth and related programs.
Cons of equity financing - the other side of the coin is giving up pieces of a startup company and their often unknown value to external investors. Because of this unknown variable, equity investments can often be a much more expensive way to raise money. Furthermore, you now have outsiders being involved with making decisions in your company and their advice is often a good thing until it's not. During the negotiation period, an entrepreneur should see how an equity investor fits in, and this includes, culture, personality, trust, style, and other ways that cause long-term friction within a small, closely held company.
In conclusion, both debt and equity transactions are becoming highly technical and specialized with new techniques being added to an already complex financing environment. Therefore, it's very important for any entrepreneur to completely understand their financing options and differences since each investment comes with its own unique set of pros and cons. One Stop Capital can bring the experience, knowledge and relationships that can help guide your company through this process and onto a successful transaction closing.
The Top Ten Factors that Investors Consider when Financing a Tech Company
1. Impressive market share in an industry sector that's booming. An organization with the ability to gain more market share in a growing market is always a good bet compared to a small company in a niche market. Although laser like market focus of a niche company is good to see, multiple complementary and growing services in multiple verticals are better at reducing the risk of any investor.
2. Equity ownership of senior Management. Investors are always more interested in a business where the management also has a significant percentage at stake in the business or “skin in the game.” This builds the confidence and credibility that they, the investors, are not going at it alone.
3. Top Quality Management. Investors often look for top-quality management in a business. In fact, a company can only be as good as the strength of management and this comes from the top-down. Management with a track record of successful ventures always works best for potential investors.
4. Ability to Effectively Acquire Other Businesses. The ability to acquire and operate other businesses is a great feature for any company. Such companies are often called “platforms” and investors come calling when they are looking to “bolt-on” a potential target company in a financial roll-up and arrive at a 1+1=3 scenario.
5. Products and Services with a clear Edge. Investors like to identify companies that are clearly better than their competitions in one or more functional areas. New and modern services that are showing growth are always preferred to legacy products that have already matured.
6. Modern trends and technology. The trend is your friend especially when it comes to an innovative product or service addressing the rapidly growing and tech savvy 25 and under market. Innovative technology can also exist in the production line or customer service or in any functional area and this creates a competitive advantage for such companies.
7. Generates superior Returns on Investment. Companies with a track record of great returns on investment are the go-to when multiple investment options are available. Being able to present such success stories from days of old should be top of mind.
8. Low Expenses or lean operations. Reduced cost of operating means higher competitive value and in difficult times, an organization that can minimize expenses can withstand most challenges and live to fight another day. There is no shame in describing your penny pinching and boot strapping ways.
9. Impeccable Financial records. A great balance sheet is an important tool that determines the chances of a company in difficult times. Being able to not completely depend on debt or equity from additional investors in case of future needs is always a good thing for both the company as well as for the investor.
10. Global Track Record. The ability to operate globally has multiple advantages including a much larger client pool as well as a buffer from regional or national issues having a negative impact on the business. The labor pool in such int’l diverse businesses is also usually considered a plus.