In my role advising startups across various stages and sectors, I’ve had a front-row seat to the often stressful financing show. Whether the companies opted for the venture capital route, a family-and-friends round, or old-school debt instruments, I’ve helped founders navigate it all. The “right” financing mix for you is highly dependent on the specifics of your company, but it can be difficult to even know where to start. In this post I’ll break down the options for raising capital at the most basic level to help founders understand what solution will best meet their needs.

What is Capital?

Within finance, capital refers to the corporate securities that have been issued. The term “securities” is broad in this case, including the two types of capital that we’ll be discussing today: debt and equity.

Debt: Borrowing for Growth

A debt instrument represents money borrowed by one party – the “debtor” – from another party – the “creditor” – with the obligation to repay the loan. In general, the repayment of the loan must include interest or finance charges in addition to the amount borrowed.

There are numerous ways to categorize debt. Some of the more common classifications are:

• Secured vs. unsecured
• Revolving vs. term

Secured

Secured debt is backed by collateral – assets that are pledged. The creditor places a lien on the asset so that in the event of the debtor’s default on the loan, the creditor can take possession of the collateral and sell it to recover the debt.

Unsecured

Unsecured debt is not backed by specific collateral. As a result, creditors impose a higher interest rate on the debt to address the fact that, in the case of a default, they do not have recourse against the debtor until they have filed a judgment against them.

Revolving

Think credit cards here. Revolving debt does not have pre-determined payment amounts. Debtors can borrow any amount up to the approved limit and can repay all or a portion of the borrowed amount, with interest charged on the outstanding balance.

Term

Debtors borrow a specified amount of money for a specified duration. While there may be an option for early repayment, the note will specify how and when payments will be made.

Equity: Selling Ownership Stakes

Equity is a security that represents ownership of a business and grants the equity holder certain rights. There are many types of equity securities, including:

• Shares
• Warrants
• Options

Shares

Shares are units of ownership of corporations. They can be further classified as common or preferred shares. The rights associated with each class of shares may differ with respect to factors such as voting rights, dividend preferences, and dissolution preferences.

A note about warrants and options: the commonly accepted definitions of warrants and options can vary based on the context in which they’re being used.

Convertible Debt

Convertible debt begins as a loan, and upon an agreed upon condition or trigger, can be converted into equity. In the startup space, these are often used to bridge the time between when a company’s runway ends and when they secure funds from their next round of financing (although in some cases companies use them in lieu of an equity raise). In effect, the convertible loan allows investors to lend money now, with the option to convert the repayment into equity with the company (almost always at a discount).

While convertible debt postpones valuation discussions (no valuation is required at the time of the issuance of the convertible debt), the inclusion of a valuation cap does, in effect, set a price – just in a less transparent manner.

Debt vs. Equity

There’s no universal “right” answer when it comes to choosing between debt and equity (and, in some cases, companies will raise through both debt and equity during the same fundraising round). What’s most important is that companies’ leadership considers the short-term and long-term implications of raising through debt or equity: future fundraising, projected cash flows, and strategic planning should all be factored into the decision.

Strategic Considerations for Startups

As an advisor, I always emphasize the importance of considering both short-term and long-term implications:

1. Future Fundraising: How will this round impact your ability to raise capital in the future?
2. Cash Flow Projections: Can you comfortably manage debt repayments, or is the flexibility of equity more suitable?
3. Growth Stage: Early-stage startups often lean towards equity, while more established companies might consider debt.
4. Valuation Expectations: If you anticipate significant value increase, equity might be more attractive to investors, but is less appealing to founders.
5. Control Preferences: If maintaining control is crucial, debt might be the better option.

Hybrid Approaches: Balancing Act

Many successful startups use a combination of debt and equity financing. For instance, you might raise through both debt and equity during the same fundraising round. Startups who take on venture debt often borrow 20-35% of the amount of their most recent equity round. This approach can provide the benefits of both while mitigating some of the drawbacks.

Leveraging Intangible Assets

For tech startups, it’s worth noting that you can often leverage your intangible assets (like intellectual property) to secure loans. This approach can be particularly valuable for companies rich in IP but light on physical assets.

Conclusion: Making the Right Choice for Your Startup

Choosing between debt and equity financing is a critical decision that can significantly impact your startup’s trajectory (in particular the economics of an eventual exit). It requires a deep understanding of your company’s current position, future goals, and the broader market context.

If you’re grappling with these decisions, consider bringing an experienced advisor onto your board. The right guidance can make all the difference in navigating the complex world of startup financing and propelling your company toward its full potential.