Debt vs Equity Financing: Which is better for startup entrepreneurs?
I was on a call this morning with startups in the accelerator program at Miller Center for Social Entrepreneurship. Associate Director Alex Pan was doing his usual great job outlining the various startup financing options available to entrepreneurs today.
Alex made a comment that I realized is worth diving deeper into: when it comes to choosing debt financing vs equity financing, many entrepreneurs think of debt as onerously expensive and of equity financing as being a better deal. But that’s not accurate, in terms of true economic cost. As any first-year MBA student who has been forced to do a WACC calculation knows, debt capital is generally much less expensive than equity capital.
First, some quick definitions: A debt holder is entitled to receive principal plus interest, paid back over some amount of time. They have no claim to equity in the company, no claim to future profits, and no claim to any future liquidity beyond the principal plus interest. An equity holder is pretty much the opposite: They are not entitled to repayment of the principal, but they do have a claim to a share of all future profits in the company, and a share of any future liquidity (M&A or IPO).
Let’s take a look at a hypothetical example: Say you had one source of capital offering you $500,000 in debt financing, at 6%, amortized over five years. And you have another source of capital whispering in your ear saying “Don’t take that — I’ll give you the same $500,000, but I’ll structure it as 20% of the equity in your company. No payments required!”
Before you choose which one sounds better, let’s look at the math: The debt capital will cost you $79,984, spread over 5 years (and that interest is fully tax deductible for the company, to the extent it offsets earnings). If you think $80K is more expensive than 20% of all the future profits and equity upside in the company, then I have some pretty serious concerns about your expectations for the venture.
The problem, of course, is that most startups don’t have the creditworthiness to get the loan, nor do they have the cash flow to service the debt. That’s why the venture capital industry was created: to make a ton of money doing equity financings for companies that can’t qualify for debt financings.
The good news, of course, is that we no longer live in binary world where the choice is just debt or equity. Miller Center’s John Kohler has done great work creating innovative structures such as VPO and structured exits, there are new funds offering innovative non-dilutive non-debt approaches, and I’ve written previously about the wide range of options for startup financing today.
There are lots of alternatives for financing a startup, with pros and cons for each. But with this article I just want to puncture the debt vs equity myth.
You may end up doing a traditional equity financing for your startup, but don’t fool yourself into thinking it’s a better economic deal than debt financing; it’s probably not.