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The Debt vs. Equity (vs. Convertible Debt) Debate

Published on Aug 22, 2012

Summary

Read 'The Debt vs. Equity (vs. Convertible Debt) Debate' at 'Time to Start Up,' the small business blog by BizFilings.
For small business owners, it's one of the classic conundrums of early-stage financing: debt versus equity. The question has been complicated in recent years by the rising popularity of convertible debt, meaning that entrepreneurs have the luxury of increased financing options but the challenge of deciding which is best suited to the needs of a fledgling company. The pros and cons below provide some basic information for entrepreneurs who need help determining which option is best.

Debt financing

Acquiring money, such as a bank loan or a loan from friends or family, that must be paid back, typically with interest.

Pros:

  • Freedom. In a typical debt scenario, the borrower agrees to make timely payments to the lender, but can use the borrowed funds for any purpose.
  • Less pressure. Because the lender is making money off your interest payments and not the profits of your business, in a debt situation there's no pressure from the lender regarding the performance of your company.
  • Potential flexibility to help cashflow. Depending on the type of debt financing and the lender, there is usually some room for negotiation in terms of a payment schedule. There might be a six- to 12-month grace period when no payments are due, a period of interest-only payments, or a schedule of graduated or flexible payments aligned with your revenue stream.
  • Tax and bookkeeping benefits. Interest on debt is typically deductible, and it generally represents a fixed expense.

Cons:

  • Personal risk. To secure a loan as a small business owner, you may have to sign a guarantee that makes you personally responsible for repayment should the business fail. There are ways to get around this, such as by financing your business through business credit card loans, but most bank loans will require this, especially for unproven enterprises. This could put your personal assets, including your residence, in jeopardy.
  • Less support. The flip-side of not having to answer to debt lenders about your company's performance is that you will not receive the benefit of their advice in steering your startup.
  • Diminished profits. The need to pay off debt with revenue can eat into a company's bottom line over time.

Equity financing

Acquiring funds, such as angel or venture capital, in exchange for granting the investor an ownership stake in your business.

Pros:

  • Guidance. Securing equity financing means adding to the leadership of your company, and so it is an opportunity to find an adviser with expertise that can benefit your business.
  • "Free money." Entrepreneur magazine uses this term to describe equity financing because it does not place any repayment burden on a business, even if the business ultimately fails.
  • Prestige. To acquire equity financing, your business must be valued so that stock can be priced. A high valuation can draw attention to your company and feed the business. This too can be a double-edged sword: An overly high initial valuation can lead to a "down round" in which your share prices are valued lower than they were in a previous round of raising equity capital.

Cons:

  • Resource drain. Finding appropriate investors, pitching to them, coming to terms and closing a deal requires hard work and time, and will take you away from the task of building your company. There are also fees associated with drawing up an investment term sheet, and you will likely have other expenses as you obtain expert legal and financial advice about a possible deal.
  • Dilution of ownership. After equity financing is obtained, the direction of the company is no longer charted only by the founders, who may not even benefit most in the short-term from the business' success, depending on their proportion of shares and the conditions placed upon founder's stock.

Convertible debt financing

Acquiring financing, such as a loan from family or money from an angel investor, that begins as debt but converts to equity once an agreed-upon condition, usually a financial benchmark, is met.

Pros:

  • Attracts investors by delaying valuation. It's very difficult to put a value on an unproven startup, which can deter equity investors from putting up money. Convertible debt allows investors to provide funding while mitigating the risk that they are buying into an overvalued company and will see subsequent investors get a better deal on stock in a "down round." Typically, convertible debt becomes equity when your company raises a certain amount of money in a later round of financing, at which point the convertible note holders acquire shares at a discount, usually between 20-25 percent per annum.
  • Affordability and speed. The cost associated with convertible debt deals is typically less than for equity financing, and the deals can usually be closed more quickly.
  • Time. In essence, business owners buy time when they engage in convertible debt financing; during the initial stage, when the money is considered debt, owners retain control over the business and can shape it with the benefit of investor dollars but without the sometimes complicated relationships that go along with equity financing.

Cons:

  • Debt-related drawbacks. Whereas convertible debt financing can diminish some of the resource drain associated with an initial round of equity financing, you will still experience almost all the drawbacks related to debt financing before the convertible note becomes equity. Perhaps most significantly, if your business fails before reaching the stage when the note converts to equity, you may be responsible for paying off the debt.
  • Share loss. The conversion discount on shares could mean that by going the convertible debt route, you'll end up with less stock in your company than if you had just undertaken pure equity financing.
Ultimately, successful companies will have a mix of debt and equity financing, so it's not really an either/or proposition. Rather, the debt versus equity question comes down to a matter of timing when it's best to seek each type of financing and how to best balance the two.