Startups often need money especially when they are in their early stages. While some of them are able to attract investor community and get backed by them. However, this is not always the case, finding money can be difficult sometimes even for those who had previously raised funding from investors. But to keep the business running, an entrepreneur can also look for other funding option which is known as debt financing. Let’s delve into debt funding and see how it is different from the equity funding….!
What is Debt Financing?
Debt financing is basically both secured and unsecured loans that you borrow to run your business and promise the lending institution to repay with a particular interest. It’s as similar as you are using your credit card or taking a loan from a person or a bank when you purchase a home or a car.
As a business owner, you can apply for a business loan from a bank or receive a personal loan from friends, family or other lenders, all of which you must pay back with an interest rate. Even if you borrow money from family members for your business, they must charge the minimum interest rate in order to avoid the gift tax.
There are some of the advantages clubbed with debt financing. First, the lender who offered you money as debt/loan has no control over your business. You completely own the stake in your organization. Once you pay back, your relationship with the financier ends. Also, the interest you pay is tax deductible and last but not least it is easy to forecast expenses because loan payments do not fluctuate.
However, there is a downside too. Debt is a bet on your future ability to pay back the money to the lenders. What if your company/business does not grow as you expected? Debt is an expense and you have to pay expenses on a regular schedule. This could put a damper on your company’s ability to grow.
Finally, although you may be an LLC or other business entity that provides some separation between company and personal funds, the lender may still require you to guarantee the loan with your family’s financial assets.
If you know that debt financing is the right option for you, there are several banks and NBFC companies in India with whom you can avail it. But, you should also know about equity financing which is another option to go with.
What is Equity Financing?
Equity financing is another way of raising capital by offering your company shares to the lenders. It involves not just the sale of common equity, but also the sale of other equity such as preferred stock, convertible stock and equity units that include common shares and warrants.
While growing into a successful company, the startup goes through several rounds of equity financing and attracts different types of investors at various stages, it may use different equity instruments for its financing needs.
Now, when we talk about the advantage of equity financing, the first and biggest advantage is that the investor takes all of the risks. Whether your company succeeds or fails, you do not have to pay back the money which you received. You will also receive their support and guidance to run the business successfully. Finally, you will have enough time to grow your business as investors take a long-term view and understand that growing a business takes time.
However, there is also the downside of equity financing which you need to understand. In order to gain the funding, you will have to give the investor a percentage of stake in your company. You will always consult with them any time you make decisions affecting the business.
Which One to Choose?
While running your startup, you will not have an option which one to choose. You should know that the formal equity financing is difficult to secure especially for early-stage startups. An angel investor follows some criteria of investing a minimum of x amount and wants to grab up to 50% of stake in the company whereas, Venture capitalists are looking for companies with global reach.
If your startup is serving a local market and does not need huge money to scale it up, then debt financing is probably the best option for you. However, larger startups often combine debt and equity financing to reduce the downside of both types.
Summing it up
In our opinion, both the funding options are important for a startup to keep running. And, the type of financing you pursue totally depends on your startup. For example, if you are just starting up, then you may consider taking a loan from family, friends or a bank. This option will provide you the liberty to operate your business in your way as well as you hold the entire stake in the company. But when you grow bigger, you would require more money to reach a larger market. At that point, equity funding may become a more viable option if you are willing to give up a portion of the stake in your company.