The SME’s Guide to Raising Capital: P3 – Equity vs Debt Financing
A version of this article orginally appeared in Gulf News.
Before we get too far ahead of ourselves, we need to discuss the type of financing that you can consider when raising capital for your business. “What kind of financing do we need?” is an important question you need to ask yourself before you begin raising funds.
Broadly speaking, there are two main types of financing you can seek: debt, which is in essence a loan that is paid back with regular interest payments, and equity, which involves the exchange of company shares for capital.
A mature business will likely have a combination of equity and debt financing; in fact, it is healthy to do so, but each type is suited to specific goals, business models, and stages of development in a company’s lifecycle. They each have pros and cons. We at Eureeca focus on equity financing but when we think debt financing is more suitable we will recommend the entrepreneur go to a peer-to-peer/business debt platform instead. Likewise, those platforms refer deals to us when equity is the better option.
Here’s a breakdown of equity vs debt financing:
Debt financing typically comes in the form of a loan or a bond that is paid back at a predetermined interest rate over a fixed period of time. For example, you can take a loan out from a bank (HEALTH WARNING – banks don’t lend to SMEs so don’t waste too much time there) in order to hire new staff, or you can issue a bond to an investor that will pay an interest rate, or coupon, and must be paid back or repurchased by the issuer at a fixed future point in time, known as the maturity date.
Debt is ideal for cashflow purposes — e.g. if you need to buy new inventory for your shop, which you know you will sell within a few months — and one of its primary advantages over equity financing is that you avoid giving up any company ownership, or equity.
Debt has to be paid back, which necessitates regularly having cash on hand. If you’re focused on growth and are interesting in pumping your revenues back into the business, these interest payments can put a crunch on your finances. Even more concerning, though, is it if your business goes bust, which is a real risk for early-stage SMEs, then it is likely the debt will be passed to you as an entrepreneur. This is not a situation you want to find yourself in when you’ve just gone out of business.
For investors, providing debt financing to early-stage businesses in particular also doesn’t make a lot of sense in that the investment will often carry the same risk profile as an equity investment but doesn’t offer the same upside in terms of returns. The best they can do is receive their relatively low returns from interest payments, but there is also a reasonable chance of total capital loss, just like an equity investment. This is largely why banks don’t issue loans to early-stage businesses. The risk-reward profile isn’t appealing.
Businesses looking to achieve rapid growth should consider equity, which involves selling off stakes of your business in exchange for capital. The main disadvantage is, as you might imagine, that you are losing part of your business to external actors. However, these investors, who are now shareholders of your business, will only benefit financially from your business if it is successful, just like you. This serves as a great incentive for your shareholders to open up doors and help your business succeed.
Another key benefit of equity is that there are no interest payments of any kind, leaving you free to use the capital to grow your business. This is of vital importance, especially for younger businesses or non-revenue generating businesses (this is often the case for tech companies) that would be unable to make such payments.
From the vantage point of an investor, equity investments in early-stage businesses and SMEs are quite exciting in that they provide significant upside in terms of returns but also enable them to share in the business’s development and hopefully its success. For many investors, this latter point is just as rewarding as the potential for financial gains.
There is a third financing option that is used in the SME financing space that is called a convertible note, which initially begins as a debt but converts into equity once a the business raises another round of funding. It is basically a middle ground option between straight debt and straight equity, and it allows the determination of a valuation to be delayed until the future fundraising round. Convertible notes are an interesting financial product, often used by VC funds, and is one that we are considering introducing to the Eureeca platform.
Lesson Three: Understand the financing options available to your business, especially their pros and cons, and the commitments you will have to your investors. Debt and equity financing are suited for different stages of development and business types and should be chosen accordingly. You don’t want to raise equity financing when a loan would have sufficed and you don’t want to go into debt when there is no chance that you get back out or if your business’ growth will be stymied. Choose wisely or your business will suffer.
Read Part 1 – To raise, or not to raise? here.
Read Part 2 – Who should you raise from? here.