Debt vs. Equity
Equity
When investors put money into a company, they typically gain an ownership interest in that company. As a result, the original owners of the company are diluted and potentially lose some control in exchange for an investor’s capital. The amount of dilution generally depends on the amount of equity purchased by outside investors and the terms of the investment. The founders’ ownership of the company becomes more diluted with each additional round of financing. However, the company does not need to pay back investors for the equity they purchased in the company if the company fails – the investors simply lose their investment. For investors, there is an unlimited upside and the downside is capped at the loss of investment.
Straight Debt
In a debt transaction, the lender does not own any part of the company, and like any loan, you must repay the debt plus interest in whatever time-frame is agreed upon. Typically in early stage companies, you can see debt transactions with venture banks and capital lease transactions. Where equity investors often participate in how the company is run, through holding a board seat for example, lenders typically have a more hands-off relationship in the company’s governance. However, debt investments usually contain some contractual provisions that attempt to control the company’s behavior. Debt must be paid off if the company fails, and you may be held personally liable for such repayment.
Convertible Debt
One of the more frequently used options for early-stage companies is convertible debt. Convertible debt is an investment that is initially structured as debt, but converts into the company’s equity in certain circumstances. Thus, it contains elements of both debt and equity. Convertible debt usually takes the form of convertible notes. Convertible debt instruments such as convertible notes contain repayment terms as a straight debt instrument would, but they also contain provisions relating to conversion of the debt into equity. Generally, interest accrues on the principal amount of the convertible note. Many convertible notes also provide for a conversion discount, meaning that the notes convert into equity at a discounted rate, which is often 10 to 15 percent. Many convertible debt terms are negotiated and vary depending upon the company’s specific circumstances.
Venture Debt
Venture debt is a form a debt financing that is geared towards early stage or venture equity-backed companies that lack the assets or cash flow for traditional debt financing. Generally, venture debt is structured as a three-year term loan or series of loans, with warrants for company equity. Venture debt is usually senior debt that is secured by a company’s assets or by specific equipment. Proponents of venture debt assert that it can reduce dilution, extend a company’s runway, or accelerate its growth with limited cost to the business. However, venture debt is not as beneficial for companies who have a low cash balance, when a company’s debt payments will amount to more than 20 percent of its operating expenses, or when a company has stable revenue streams and receivables.