Raising funds is a major milestone for any business, especially a startup. However, with so many options, it can become overwhelming for founders to decide which type of capital is right for them.
When considering sources of capital most business owners think in terms of debt and equity. However, there are many flavors and combinations of debt and equity, and there isn’t a one-size-fits-all solution for every business.
This is why it’s important to view capital in strata or layers, as a ‘stack’, instead of an individual decision. Different types of funding may make the most sense at different times in your business, or for different initiatives and stages of growth.
There are several types of equity and debt as well as other sources of capital that can help your start-up reach the next level of success:
- Senior Debt
- Mezzanine Debt
- Convertible Debt
- Preferred Equity
- Common Equity
- Other sources of capital:
- Grants and government incentives
- Retained earnings
Using Equity vs Debt to Fund Your Startup
When it comes to funding your business, there are two main types of capital – equity, and debt. While both of these options can provide necessary funding for your business, there are pros and cons to each form of capital.
Debt is the process of taking on a loan that needs to be repaid. While ‘debt’ may sound scarier than ‘equity’, the advantages of leveraging debt in your business are that it allows you to maintain autonomy in your business, and can give you more control of your business decisions moving forward.
Equity is an important part of your business’s financial structure. For Solopreneurs, small teams, or founder-only startups, having 100% equity in your own business means that you take all the risk, but also get all the reward! Sharing this equity with other stakeholders is a great way to increase the capital in your business, leverage the expertise and advice of seasoned investors, and limit debt in your business. However, by definition, it means you are giving away a portion of your business. Are you ready for that?
Each business owner, based on their current stage and future goals, will have a different tolerance and desire to fund their business with debt or equity. In many cases, incorporating both equity and debt into your capital stack will be the best route for you!
It’s important to keep in mind that the ratio of debt to equity in your business may impact your future capital options, so it can be advisable to work with business advisors and financial planners to determine your long-term strategy to help make certain that your financing choices are made with the future in mind.
How to Choose the Right Capital Stack For Your Business
Choosing the right capital stack for your business is a unique and personal decision, and can be influenced by a variety of factors. While you may read or hear that one type of funding is better than another (the glamorous stories raising VC capital can be alluring to any startup founder!), it’s important to work with your financial team to come up with a plan that suits where your business currently is, and your goals and dreams for where you’d like it to go.
This is the beauty of having a capital ‘stack’ instead of a single form of funding for your business – different streams of capital can help fund different components of your business, and be leveraged at different times. Instead of committing to one form of capital, having multiple options empowers you to make the best decision for your business at a given moment.
There are many practical considerations in finding the right sources beyond the cost of a loan or equity stream. It’s important to consider the holistic view of your business, goals, and alignment with various capital streams. Before deciding on a path, it’s important to ask yourself the following:
- How much capital will you be able to get from each source?
- Are there any covenants (read: restrictions) that you have to follow once you take the money, including how the funds must be used?
- Are you giving up some control over your business, or gaining value from the expertise of your investors, and how does this relate to the economic cost of the capital?
- How much time and effort will be involved in getting the capital? What will you have to prepare for diligence and who will work on it?
- What is the economic cost?
- For Equity: What are you giving away?
- How much of the company are you selling?
- What’s the valuation?
- For Debt: What’s your interest rate, fees, and any pass-through costs?
- Prepare a cash flow profile to better understand your business’s ability to take on this type of debt.
- For Equity: What are you giving away?
- Does this limit your ability to raise additional capital in the future? Does it make it easier?
- Some of these can be technical reasons (i.e. relating to covenants)
- Some of it can be more subjective (i.e. can they introduce you or help raise your profile to other investors or lenders)
Companies should consider not just their current needs but, also, future needs. A diverse capital stack that provides flexibility and room to grow will set up for successful capital raises in the future.
Types of Capital
Senior debt is generally provided by banks or bondholders. This type of debt is usually in the form of a line of credit available to the business, and is secured through collateral in the business, making it a low-risk debt option for lenders. The defining factor of senior debt is that in the event of a bankruptcy, the senior debt holders are the first to be repaid.
Mezzanine debt bridges the gap between debt and equity financing. It is a high-risk form of debt where the issuer is able to convert their debt to equity in the company in the case of a bankruptcy or default on the loan.
Convertible debt is acquired through a group of investors, with the expectation that the debt be used to generate equity and revenue that is distributed in the future. The terms of future payout are established at the time of the investment being made and can be a great way to independently seek out funding for your business.
Preferred equity is a category of shareholder equity that gives preference when cash or equity payouts are being made.
Common equity is a standard class of shareholder, which is generally last on the priority list for receiving payouts and dividends after preferred equity holders and other debt classes.
Grants and Government Incentives
Grants and Government incentives can assist businesses in a variety of stages to grow their business or weather difficult times. Incentives are usually targeted at a specific area of your business, for example, hiring or investing in technology. Grants can also be an attractive option for young, female, or BIPOC founders seeking support and additional funding.
Crowdsourcing is an excellent way to raise initial funds for a new startup or product. Instead of a loan with interest, these contributions are often in exchange for a product or service once the funding goal has been met. This is a particularly powerful tool for products or services that solve social issues and have a compelling story. The power of crowd-funding sites such as Kickstarter has allowed startups to share their story and promote themselves ahead of launch, all while raising low-risk capital.
If you have been in business and generating a profit, your corporation can rely on retained earnings to fund future growth. Retained earnings are one of the lowest-risk ways of growing your business, but can take longer to generate and can potentially slow growth depending on your revenue compared to your needs. Work with your financial team to see what the most tax-advantaged breakdown of retained earnings, dividends, and payroll makes sense for your business.
While there are several types of debt or equity a business can take on, it’s never an “either-or” choice, but more so a constant exercise at building up your capital stack to prepare you for the next stage of growth.
Looking for guidance on how to prepare your business for raising capital? Our team of experts will help guide you through your options, prepare the right financial documents, and take the headache out of financially preparing for funding!