One of the first questions that a startup faces when it begins to look outside the organization to fund itself, is what type of financing to seek. There are some who will argue that one type of financing is inherently superior to the other for startups. But to me that’s kind of like saying that a hammer is inherently superior to a screwdriver. Neither form of fundraising is inherently superior to the other. The answer to the question of which type of financing to seek depends entirely on the startup’s stage of development and the options it has in front of it.
Debt financing is just another name for a loan. And just as with a loan you might take out from a bank or other credit agency, it almost always carries with it a stated interest rate that you must pay off over time. While many smaller businesses receive loans directly from banks or the Small Business Administration, this type of financing for startups is also common among angel or “friends and family” investors.
Debt financing has a number of advantages. For one, interest on business loans is typically deductible. Unlike with equity, it is does not usually force the borrower hand over ownership or control of the company.
The primary disadvantage is that many startups are not immediately cash-flow positive. If that’s the case, paying off the loan might supplant growing the business as the primary financial focus of the company. Also, inexpensive loans on good terms are hard to come by for companies with little or no track record.
Equity financing refers to the process of receiving money in exchange for an ownership stake in the business. Unlike with loans, there is no direct obligation to pay the money back to the lender. Instead, the lender acquires rights alongside the founders to whatever value the company manages to grow into over time.
Exchanging ownership for money is often a convenient way for businesses that know that they aren’t going to earn money for a while to stay afloat in the meantime. The problem is that the less the founders own, the less incentive they have to develop the business. Also, founders must choose their equity investors carefully, because equity investors have a say in what happens with a business. Choose the wrong equity investor, and you may lose the right to run your business the way you want.
Another issue with equity financing is that it can create securities law problems. Selling equity to the wrong person or to too many people without making the proper filings with state and federal securities agencies is a big no-no, punishable by fines and even jail.
If you’re looking to sell equity to anyone who isn’t a founder in the company, you should seek the advice of a qualified securities lawyer.