Debt or Equity: How much and When?
When it comes to financing a startup , there are a variety of financing instruments available. Typically, these are classified into 3 categories: debt, equity and alternative financing. In this blog, we will explore debt and equity instruments and learn the appropriate levels of each for different scenarios. Alternative financing will be covered separately.
What is debt?
Debt financing involves borrowing money from a lender, such as a bank or other financial institution, and paying it back over time with interest. This type of financing can be a good option for businesses that have a steady cash flow and can make regular payments on their debt.
However, it's important to be cautious when taking on debt. Taking on too much debt can put a strain on cash flow, making it difficult to meet other financial obligations. Depending on the interest rate, debt can also erode profits that could be reinvested in business growth. As a general rule, businesses should aim to keep their debt-to-equity ratio below 1:1.
What about equity?
Equity financing involves selling a portion of the business to investors in exchange for capital. This type of financing can be a good option for businesses that are high-growth and have the potential for significant returns. The main drawback from this type of financing is that founders may lose control over decision-making and may be required to provide regular updates to investors.
Appropriate Financing for Different Scenarios:
Short-term financing needs: If a business needs financing for a short-term project or to cover a temporary cash flow shortfall then debt may be the answer.
Existing assets: If a business has existing assets, such as inventory, equipment and property, that can be used as collateral, they may be able to secure favorable terms on a loan. Most banks are biased towards immovable assets (i.e real estate) and expect that the asset will be at least 120% value of the loan.
Predictable revenue streams: If a business has predictable revenue streams through regular contracts or subscription-based services, they may be able to secure a loan based on their expected cash flow.
High-growth potential: If a business has the potential for rapid growth and significant returns, equity financing may be the best option. This can allow the business to access capital without taking on significant debt.
It is important to show evidence of traction to demonstrate high growth potential. No traction means no proof of concept and not all traction is equal. Try to focus on acquiring and retaining repeat customers.
Strategic partnerships: If a business is seeking to establish strategic partnerships or enter new markets, equity financing can provide access to investors with valuable industry experience and connections.
As implied in the scenarios above, debt is more appropriate for high growth sector industries while equity is perfect for highly demanded innovative products. The key words are 'growth' and 'demand'. To be successful in fundraising, it is important to strategically position your company in a promising industry niche that can receive both instruments at different stages of your business.
Enea Advisors can help you navigate the complex world of financing and develop a financing strategy that meets your unique business needs. Contact us today for a free 1 hour session to learn more.