by Martijn Lentz
Funding your startup with equity or loans? You don’t have to choose one. KVK breaks down the perfect mix of debt & equity funding. While there are no hard and fast rules, if you are setting up your business, it makes sense to strongly consider equity financing in order to get the business off the ground. Investors don't require fast repayment, and most startups don't turn a profit for a significant time period. If you are getting a steady revenue stream, then loans make a lot more sense. In addition to this the ‘use’ of the money is important for the route debt or equity. All in all it’s the right mix that fuels your startups’ growth.
The mix of equity and debt
As a founder it’s important to understand the difference between debt and equity financing, by angel investors or venture capitalists (VCs). No hard or fast rules apply.
Equity financing involves giving a portion of the shares of your company to investors in exchange for money. Investors will provide equity financing when they are convinced of the upside potential of your company in the future. The portion of the shares that will be sold depends on the valuation of your company at the time of the financing.
When a company borrows money from third parties to be paid back it is known as debt financing. A startup typically takes up a loan to finance working capital. Lenders will provide credit when you can explain how you can ensure back payment. A company takes on debt financing because it’s often cheaper and less risky than financing the whole growth with equity. Too much debt however is also risky and thus, founders have to decide the debt to equity ratio which they are comfortable with.
Although many founders regard giving third parties an interest in their business as losing control, this doesn't have to be the case. If you choose the right investors, they can be extremely helpful in terms of establishing business connections and offering valuable advice and assistance. Also committed investors are instrumental in attracting more investors if necessary.
- Unlike equity, debt must at some point be repaid.
- The larger a company's debt-equity ratio, the more risky the company is considered by lenders and investors. Accordingly, a business is limited as to the amount of debt it can carry.
- Debt instruments often contain restrictions on the company's activities, preventing management from pursuing alternative financing options.
- The company is usually required to pledge assets of the company to the lender as collateral, and owners of the company are in many cases required to personally guarantee repayment of the loan.
The biggest advantage for choosing loans is that you maintain control over your business. The only obligation you owe to your lender is to repay the loan as agreed upon. An advantage that can be very helpful is that paying off the interest on the loan can be deducted as a business expense for tax purposes.
- Debt does not dilute your ownership in the company.
- A lender is entitled only to repayment of the agreed-upon principal of the loan plus interest, and has no direct claim on future profits of the business.
- Interest on the debt can be deducted on the company's tax return, lowering the actual cost of the loan to the company.
Martijn Lentz is a KVK Entrepreneurial Financing Expert. During Amsterdam Capital Week 2018, he will post a short daily blog on ‘How to raise capital in five days’. Do you have any questions? Contact KVK’s Startup Information Desk 00 31 88 5852222, or e-mail firstname.lastname@example.org. You can find Dutch info on KVK.nl/startups.