No good business idea can be realized without the capital to back it up. When faced with the choice between debt and equity financing as the two primary options for startup funding, how do you know which one will be more advantageous as you position your business for growth?
To help SaaS founders decide, here’s a direct comparison between debt financing and equity financing, the pros and cons of each, and the optimal capital structure to have in place.
Debt Financing vs. Equity Financing
So which financing type should you go for? The answer is that it depends on various factors such as current economic conditions, the stage of your business’ life cycle, and the capital structure that you’re using.
Debt-based financing is considered to be an alternative to equity capital, with bank and non-bank lending being its most common forms. Since debt capital is non-dilutive and only the cost of debt has to be paid for, it’s what founders of startups or small businesses usually go for to initially launch their businesses.
On the other hand, equity-based financing is dilutive and will require you to give up a portion of your company to the lender, in exchange for the lump sum that will help you manage your business. This is often the go-to option for founders who have pre-revenue startups, or have to manage business expenses that have already exceeded their earnings. Venture capital, angel investors, and private equity are some common examples of equity-based financing.
Raising Capital is a Risky Thing
While both may work for early-stage SaaS companies, they each entail their own risks. In debt-based financing, you run the risk of losing assets you’ve declared as collateral if you miss your payments. Additionally, incurring too much debt can reduce your company’s ability to raise additional capital, effectively taking a blow on your business operations and growth trajectory.
As for equity-based financing, raising too much equity capital may result in the loss of ownership or control of your business. Since investors have an ownership stake in the company, they may also have a say in how future stakes will be sold. For example, if you decide to sell a 55% stake to other investor/s, a current stakeholder has the power to intervene and take over the company if they’re not getting the results they want.
Pros and Cons
|Debt-Based Financing||— A good funding alternative for business not deemed fit for venture capital or private equity|
— You have full control of the business
— Presents some tax benefits; considering that you use accrual accounting, you have a decreased taxable net income which makes the cost of debt lower than your declared rate of interest
|— Potentially high cost of debt|
— Business assets may be put at high risk
— Could restrict your access to additional funding/equity funding
|Equity-Based Financing||— No obligation for monthly payments, especially if your business isn’t generating profit at the moment|
— Repaying investments is not required
— Expands your network; investors not only impart capital, but also their contacts and strategies.
|— Cost of equity is generally higher than cost of debt|
— Attracting investors may prove to be more challenging than applying for a loan
— Your ownership position in the company can become diluted
The Optimal Capital Structure
Your existing capital structure will heavily influence your decision because it will dictate whether your company has a low or high cost of capital, and if the company’s market value is maximized. That said, there has to be an optimal balance between lower-cost debt and higher-cost equity for the structure to be truly effective.
It is important to note, though, that companies are not required to take on debt and can adopt an all-equity structure. But generally speaking, an optimal capital structure does the following:
- Boosts the company’s market value. An optimal capital structure maximizes the company’s market value and net worth, discounted by your WACC.
- Decreases the cost of capital. A lower cost of capital reduces your risk of becoming unable to pay for loans, and increases the current value of your future cash flow.
- Maintains control. A flexible capital structure enables you to take on debt or future borrowing if and when necessary, while still maintaining control over your rights and obligations.
Whether you go with debt- or equity-based financing, the option you choose today will determine where your company will be one, ten, or even twenty years from now. While your business is still in its early years, weigh your options and be aware of the risks. Think long and hard about how you want your capital and finances to flow, as well as how much of each you’re willing to give up to achieve long-term growth.