Debt vs. Equity Financing: Pros And Cons For Entrepreneurs by Alejandro Cremades

TL;DR - Pros and cons of fundraising from debt, equity, and the in-between.

Helpfulness - 5

Topic Tags - Financing, fundraising, equity, debt, cash flow, debt-equity ratio, tax-deduction, convertible notes, SAFEs

Questions answered:

  • How will business debt affect equity fundraising?
  • What are the pros and cons of equity and debt?
  • What are the different types of debt?
  • What is a convertible note?
  • What is a SAFE?
  • What should founders keep in mind when fundraising?

Summary:

  • Funding with debt means you stay in control of your business, but payments must be made regardless of your earnings. Business debt can also create tax deductions, which can help maximize profit in positive cash flow.
  • Founders must also understand that the financing terms may change over time, watch out for variable interest rates, maturing balloon debt, and revolving credit lines.
  • Too much debt will hurt equity raising because profitability and valuations fall in relation to debt.
  • Convertible notes are a form of debt that can be exchanged into equity. An exchange happens if the next round of fundraising is secured, if not, the CN is still debt that must be repaid. Founders should look out for the interest rate on the debt, the discount on the valuation (when converting to equity), and cap (the maximum price of a share converted from debt). CN is a fast and cheap way to raise money. The maturity date is a deadline.
  • SAFEs or Simple Agreement for Future Equity is a more founder-friendly CN as it does not accrue interest or have a maturity date.
  • Venture Debt is normally sourced from special banks and has varying terms.
  • Founders can raise lots of money fast from equity, and there is no cap and It is also available to start-ups without positive cash flows, unlike debt.
  • Equity rounds take lots of time, you split your profits, and may lose control.

Follow-up Links:

More on SAFE and KISS