Need some practical advice about whether you should use debt or
equity financing during the startup stage? Here are a few tips to
help you choose the best source for your business.
When it comes to the financing popularity contest, equity
funding is currently in vogue. Articles in the mainstream media
about venture capital have glamorized the concept of selling stock
in your startup, and entrepreneurs across the board would much
prefer to raise money in the form of equity rather than debt.
Why is equity so appealing? Because it feels like you're
getting "free" money during the startup stage. There are
usually no repayment obligations and no interest payments due to
equity investors. You'll also have some say in negotiating the
price of your stock, any dividend payments and the position the
investor will have in your company. If your business goes belly-up,
it's their loss (unless, of course, your investors can prove in
court that you didn't disclose critical information that would
have influenced their decision to invest).
Content Continues Below
Besides providing funding, equity investors can be helpful in
other ways as well. They bring their business experience and
lessons learned to bear on your company, and they can become a
trusted advisor, mentor or board member. The best equity investors
are those with expertise in your industry, experience launching a
business, a cool temperament and deep pockets. Some say choosing an
equity investor is like getting married--you're making yourself
accountable to this person through thick and thin, so choose
carefully.
Before you go investor shopping, though, you should carefully
think about just what you're selling and what having equity
investors really means for you and your business. Very few
businesses will ever be able to deliver a decent return on
investment (ROI) for equity investors. The typical restaurant or
retail store, for example, is unlikely to have any liquidity for
its shares. And even if you plan to have a high-growth tech
business, the chance of reaching liquidity for your early investors
is low. You must be honest with yourself about whether your
investors expect to be paid back.
Assuming you won't have a glamorous initial public offering,
you'll need to find a way to allow your investors a graceful
exit. One option is to find a new wave of investors willing to buy
out the old ones at a share price that feels like a win-win for
all. Another option for investors--especially friends and family
who want to stay involved--is to convert equity positions into
loans. In my role as president of CircleLending, I've
encountered these loan conversions quite frequently, even though
equity investors typically have no legal recourse in the event the
business fails. This is one of hidden secrets of startup
financing--that equity investments from relatives, friends and
other startup investors often morph into loans if the businesses
fail.
But what about good, old-fashioned loans? If the sheen of equity
capital is tarnished by the reality of having to generate a
respectable ROI, you can fall back on the old familiar friend: a
loan. The good news about debt financing is that you're still
completely in charge of your business--your only duty to your
lender is to make your payments on time, as spelled out in your
promissory note. As long as you do that, your lender has no right
to meddle in your business. Interest payments are typically a
deductible business expense, and if your lender is someone you know
well, you may be able to get favorable repayment terms that can
make the loan walk and talk much like an equity investment.
There are several ways to create this flexibility:
- Defer the start date of repayment by adding a "grace
period." Startup loans often have a six- to 12-month grace
period before repayment starts, providing entrepreneurs with some
time to ramp up the business.
- Capitalize interest. Your lender can also capitalize the
deferred payments so they don't lose interest funds during the
grace period. This allows you to pitch a lender by suggesting a
much longer grace period (if you think you'll need more than 12
months).
- Use interest-only payments. If your lender wants to be
repaid immediately, offer to make interest-only payments for a
period of time to keep your monthly budget in check.
- Institute graduated payments. You can create a unique
repayment schedule with low payments at the start of the loan and
higher payments at the end when your business is proven.
For lenders who are very cautious about making a loan, you can
offer to provide collateral on the loan, such as a lien on your car
or home equity. Be careful, though: If your business isn't yet
well established, taking on this type of risk too early could be a
bad move.
Another solution that some entrepreneurs have used to find a
happy middle ground between debt and equity financing is
convertible debt, which is simply debt that converts to equity as
the business grows. Next month, I'll go into detail on this
financing option, so look for my column in May.