Understanding Debt & Equity Options for Funding Your Startup

Understanding Debt & Equity Options for Funding Your Startup

To fund business operations and finance the purchase or procurement of assets (i.e., real estate, equipment, vehicles), companies often rely on a mixture of debt and equity financing.

The mixture, or structure, of a company’s debt and equity is referred to as its financial structure, which is sometimes referred to as its capital structure. (Capital structure, however, refers solely to the long-term debt and equity of a company, while financial structure refers to both long-term and short-term.)

There are different types of equity and debt (referred to as equity capital and debt capital) that you can use to fund your business, each with their own pros and cons, and understanding the most common types you’ll likely choose from is essential as a startup founder.

Further, with the basics of debt and equity financing under your belt, you’ll be able to choose the right mix of debt and equity and establish a financial structure that suits your company and current situation. (It’s important that you make these decisions with the help of financial managers and professionals, however.)

It’s important that entrepreneurs and nascent startups understand the basics of debt and equity financing options for funding business operations.

In this article, we’ll review the common types of debt and equity biotechs generally use to fund operations and fuel company growth. But first, let’s review the basics of financial structures, debt vs. equity, and the differences between private and public financial structuring.

What is Financial Structure?

Overall, the term “financial structure” refers to the mixture of debt and equity capital that fuels a company and its operations.

Debt capital is raised from sources like credit investors, and is paid back over time and involves interest payments. On the balance sheet, it’s represented as the short- and long-term liabilities a company is obligated to pay. Equity capital, on the other hand, is raised from investors who become shareholders and receive a return on equity (such as distributions and market value gains).

The financial structure of a company shows the ways it has raised capital to buy or lease lab space, equipment, supplies, consumables, hire scientists, run experiments, conduct studies, and more—all the things that make up the foundation of your business.

That said, there are other types of liabilities outside of traditional debt financing or equity financing that can be involved in the financial structure. This includes unearned revenue, tax obligations, and accrued expenses, among other examples. In general, however, the financial structure will mostly consist of debt and equity sources of funding.

A startup’s financial structure, or balance of debt and equity, will depend on its needs and expenses, and, when managed correctly, will help the startup fuel operations without running out of funding. The structure can also be influenced by investors who want to see a company use both classes of capital, rather than just one.

Ultimately, if its financial structure is lopsided, or becomes lopsided, a company risks running out of the funds it needs to achieve goals and milestones.

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What is Debt vs. Equity?

Simply put, debt is different from equity in that it involves borrowing money to be repaid, plus some form of interest, while equity involves raising money by issuing shares in the company that represent a shareholder’s ownership interest.

Each type of financing comes with its advantages and disadvantages, but the most important distinction is the repayment of debt, the exchanging of equity, and the cost of capital.

While debt comes with strict obligations regarding payment of the principal plus interest, it doesn’t require you to give up equity in the company. Equity, in contrast, requires that you give up shareholder equity to the investor in exchange for working capital.

However, that amount is often much more than you’d receive through debt financing, and does not need to be paid back.

Depending on your situation, you’ll consider whether you want to pay back a loan (often for something specific) and retain control of your company or exchange equity for a much larger amount of working capital that can be used in a myriad of ways.

Types of Debt Financing

Debt financing occurs when you sell a debt instrument to various types of financial institutions who act as lenders, such as banks and credit unions.

By selling the debt instrument to the lender, you raise working capital to fund an aspect of your business’s operations, and, in exchange, promise to repay the lender the principal and interest on the debt.

The type of debt financing you choose should depend on the cost of capital, represented by the minimum return your company should earn on the capital to satisfy its lenders, shareholders, and any other provider of capital. That means understanding the types of debt instruments available to you.

Debt instruments, or assets with a fixed payment that involves interest, include credit cards, lines of credit (LOCs), loans, bonds, leases, and more.

Types of Equity Financing

Equity financing involves a number of sources, such as angel investors, individual venture capitalists, venture capital firms, and corporate investors. Depending on the industry, equity crowdfunding may be applicable and relevant too.

Typically, the fundraising process of equity financing involves a number of priced rounds, which eventually lead to an IPO. A priced round is an equity investment based on a negotiated valuation of your company.

Once you have agreed with the investor on your company’s valuation, they will provide you working capital in exchange for stock at the agreed-upon price-per-share based upon the negotiated value.

Securing equity financing can sometimes be a more straightforward process than debt financing, but you’ll need to have a business plan, product, and (in many cases, but not all) financial projections that investors are excited by if you’re going to raise a priced round and secure financing.

You will also need to be okay with giving up a portion of your company in exchange for the working capital.

Debt/Equity Hybrids & Other Examples of Financing

Convertible Notes

Simply put, convertible notes are a short-term debt that can convert into equity. The debt generally is automatically converted into shares of preferred stock upon the closure of a round of Series A financing.

Convertible notes are many people’s favorites because they provide a faster and sometimes cheaper alternative to offering an equity round. As the notes are expected to convert into shares of stock, it is extremely rare for individuals to want to get their money back instead of receiving the stock.

It is worth acknowledging that the note relies on debt, and thus does not show up on the capitalization table. It is often the view that debt is cheaper than equity, and convertible notes are considered debt until converted, at which point the debt becomes equity.

This makes them a liability on your balance sheet, as those that hold notes do not become stockholders and join your cap table until they convert. For owners looking to prevent dilution, convertible notes can be a powerful tool, especially if they are capable of paying off their notes in full.

Simple Agreement for Future Equity (SAFE)

Contrasting with convertible notes, a simple agreement for future equity, or SAFE, is a method of simplifying seed investment by providing a warrant to purchase stock in a future priced round.

Although it is not technically a debt/equity hybrid, and is treated as a type of equity financing, SAFE notes are seen more as a type of warrant. It is a contract that says that the company will offer you, as an investor, equity in the future for the money you are putting down now.

The SAFE is an extremely straightforward option, as you can just download a form, fill in the blanks, and be done with the process. It offers an inexpensive and expedient methodology to get money into a company.

As a SAFE isn’t a debt instrument, it doesn’t have interest, an interest rate, or a maturity date. This reduces the pressure for startups to have the next round of financing happen within a certain time frame.

Side Letters

A side letter is a formalized method of negotiating an agreement between an investor and a private fund or company.

Side letters are a mechanism that companies use to incentivize investors by giving certain investors additional rights, such as rights to certain additional information and the right to participate in a defined set of management decisions, both not normally provided to investors.

These agreements often have different stipulations than the primary financing documents, and it is often simpler to create a side letter agreement instead of changing the primary documents for all parties. These side letter addendums are often necessary to secure certain investors.

Parting Thoughts: Accepting Investments

All types of business financing and investment have their pros and cons. In most circumstances there is no perfect financial structure, and it makes little sense to turn down investments because they do not fit your ideal, whether or not they are from a lender/creditor or an equity investor.

Many financial advisors and startup veterans will choose to accept the inflow of money as long as the conditions make sense, as these financing activities provide much needed cash flow.

After all, interest by investors depends on the economy, developments within the industry, and the potential market for whatever your company is offering.