Financing Your Growth-Stage Company: Choosing Between Equity & Debt
During the growth stage of your company, scaling up will require ongoing financing. In the best case scenario, you are generating enough profit to self-fund your growth initiatives. However, such circumstances are rare. More often than not, tackling the growth stage means finding an investor.
If finding an investor is on your radar, it’s important to be aware of and consider the various investment structures available for growth-stage companies. Being fully informed will allow you to commit to an arrangement that makes the most sense for your company’s unique current and future needs.
Before you reach out to any type of investor, you will need to make sure your company is in a position to attract the kind of investment you’re looking for. For growth-stage companies, you should already have a solid management team in place and a validated concept with concrete traction. Now you need to work on securing your revenue projections and having growth initiatives in place.
When it’s time to decide which type of financing you want, an age-old question inevitably comes into play: debt or equity?
Equity financing involves raising capital in exchange for a percentage of ownership in your company. The goal of the investor is to generate their returns once your company has gone public or has been merged/acquired.
For growth-stage companies, equity investors will look to see if you are operating in established markets with proven unit economics. Although the company may or may not be profitable, companies should be able to exhibit potential for profitable revenue growth. This is shown through repeatable and scalable customer acquisition process and a customer lifetime value that exceeds the cost of acquisition.
Before you begin the quest for equity financing, consider the following advantages and disadvantages:
- No Need to Repay Investment – Equity financing does not involve traditional repayments you would find with a debt loan. Instead, equity investors will use equity as their form of return as the company continues to grow.
- Cash Flow – Because you are not repaying your investor with traditional repayments, the investment you receive is a pure addition to your cash on hand. This means you have the freedom to use the cash to grow your business without worrying about having to service a loan.
- Advisement – Many founders consider equity financing despite its high dilution because they value the relationship with VCs very highly. FXCM mentioned technically expertise and management experience are among the factors investors provide to the companies they invest in. While not all investors are positioned to provide relevant experience or advice, you may want to weigh whether an investor can provide more than just money. Being able to access their broader business network and/or benefit from their knowledge can be a valuable asset.
- Cost of Capital – The more equity financing you use, the more equity dilution you face. Although giving up equity may seem like a better trade-off than monthly payments over three years when your company is pressed for cash, equity financing is considered the most expensive form of financing. If your company is successful, the value of that equity far surpasses the amount you would have paid with debt financing.
- Loss of Control – On top of giving up equity, you will also give up some degree of control. Equity investors want to have a say in company decisions that will impact the value of the company.
- Potential for Conflict – Since equity financing involves giving up some control, tension and conflicts can erupt as disagreements arise in terms of management styles and visions for the company.
Debt financing involves loan structures where the amount “invested” is paid back by the company. While the company does not have to give up control of the business unlike equity financing, too much debt can inhibit the growth of the company.
- No Equity Dilution – Debt financing involves no exchange of equity, which means you are able to raise capital while avoiding equity dilution. This makes it a much lower cost of capital compared to equity financing.
- Predictability – Most debt financing structures involve a principal and interest payments. Since these are stated in advance, it is easier to work these into the company’s cash flow.
- Maintain Control – Since debt loans are temporary, the relationship ends when the debt is repaid. Because of this, companies that take on debt financing do not have to give up control, so lenders have no say in how to run the business.
- Cash Flow – The most fundamental disadvantage of debt financing is that the agreement can cut into your cash flow. The idea is that the funding you receive allows you to grow your business, bring in more cash, and thus handle payments with ease. However, if growth is slow and you still have to make scheduled repayments on your debt, you’ll have less available cash flow.
- Risked Collateral – It depends on the arrangement, but in some cases an investor funding you through debt financing will request some form of collateral as part of the agreement. The risk of losing that collateral should you default on payments can be a concern.
- Less Flexibility – Once you agree to a debt financing arrangement, the added burden of payments will likely prohibit you from additional funding, at least in the short term. because it’s a considerable burden to take on more debt. That’s not to say you can’t make a similar arrangement again at one point or another, but at least while you work through your early payments you may have less flexibility for future funding.
If you are looking for a more traditional form of debt financing with fixed repayment amounts, venture debt is a great alternative to bank loans. Bank loans often have a length application process, can be difficult to get approved for, and tend to have strict covenants and personal guarantees. Instead, many early and growth stage companies are looking to venture debt as their preferred form of debt financing.
For more information on Venture Debt, explore our Venture Debt Knowledge Center or read the following articles:
Revenue-based financing is a form of debt financing that can act like equity financing. Often dubbed “quasi-equity,” revenue-based financing provides founders the added flexibility you cannot find under traditional debt financing. Instead of fixed monthly payments, revenue-based financing calculates payments based on a percentage of the company’s monthly revenue.
For more information on Revenue-Based Financing, explore our RBF Knowledge Center or read the following articles:
- Founder’s Guide to Revenue-Based Financing
- Pros and Cons of Revenue-Based Financing
- [Free Webinar] Is Revenue-Based Financing the Right Option for My Business?
By Ruby Mace