Understanding Equity vs Debt Financing

Imagine you’re a startup founder with a brilliant idea for how to solve a problem that you have noticed in your environment, the kind that could disrupt the market and maybe even get you featured in Forbes.

 You’ve done the market research, you have a minimum viable product (MVP), and all that’s left now is capital. 

(Cue dramatic music)

Maybe you could do a little with personal funds but it probably won’t take you far and while your uncle promised to "support" you, we all know that’s just code for “best of luck, my dear.”

 You need a significant amount of money to scale so how do you go about fundraising? Equity or debt financing?

Let’s break it down without the financial jargon that makes your head spin.

Two of the most common ways of financing your startup are equity financing and debt financing. Knowing the difference between these two will help you make the right decisions for your business and can determine the amount of control you retain in your business, the speed of business growth, and how you manage financial risks.

In this post, we’ll break down each of these funding options so that you are well-equipped with the information you need to finance your startup.

What is Equity Financing?

Equity financing involves raising capital by selling a portion of your company’s equity (ownership shares) to investors. When this is done, the investors then become partial owners of your business and they subsequently share in the company’s profits. Instead of borrowing money to raise capital, you’re giving up a percentage of ownership.

An example of this is when you need to raise capital to fund the expansion of a business you own. You may decide to give up 5% of ownership and sell it to an investor who will give you the capital you need in return. That investor is now a decision-maker in your business and needs to be carried along in all business decisions.

 With equity financing, even though you are not required to repay the money you raised through it, you are now under pressure to ensure you provide your investors with a good return on their investment in your company.

 Some sources of equity financing are:

·         Angel investors

·         Crowdfunding

·         Venture capital firms

·         Corporate investors

·         Listing on an exchange with an initial public offering (IPO)

·         Private Equity

 Securing equity financing can be simpler than debt financing, but you need to have an extremely attractive product or financial projections, as well as be able to surrender a portion of your company and some level of control.

Pros of equity financing

·         There is no obligation to repay the money you received from investors 

·         New startups prefer to use it to raise funds so that they don’t have to worry about being indebted to anyone.

·         You have access to investors with relevant business expertise who can provide mentorship and connect you with people who may be helpful to your entrepreneurial journey.

 Cons of equity financing

·         You cede control of a percentage of your business so you no longer own 100% of your business.

·         You will have to share future profits with your investors

·         Fundraising via equity financing could take longer than expected as it requires due diligence and extensive negotiations

What is Debt Financing?

Debt financing involves taking out a loan usually through a traditional lender like a bank. You’re basically borrowing money and paying it back with interest according to an agreed-upon schedule.

This form of fundraising could sometimes be accompanied by restrictions on the company’s future activities. These restrictions could prevent you from taking advantage of other business opportunities that may arise. Ensure you read the fine print of the loan’s contract before signing.

 With debt financing, you’re obtaining a loan from a financial institution that will be repaid with interest (fixed or variable) over a predetermined period and may require collateral, depending on the financial institution and the terms of the loan.

 In Nigeria, businesses can obtain loans from traditional banks, the Development Bank of Nigeria (DBN), and the Bank of Industry (BOI). They offer different loan products tailored to SMEs that your business can qualify for.

 Some sources of debt financing are:

·         Invoice factoring

·         Business credit cards

·         Personal loans, usually from a family or friend

·         Peer-to-peer (P2P) lending

·         Bank Loans 

·         Government-backed Loans (Loans from agencies like the CBN intervention fund or BOI SME loans)

·         Corporate Bonds

 When asking for loans from banks, your ability to secure debt financing is largely dependent on your existing financial standing and how reliable you have been in repaying loans in the past (creditworthiness).

 Pros of debt financing

·         Whoever loans you money has no control over your business. You retain full ownership (100%) of your business

·         The interest you pay on loans is tax-deductible

·         You can forecast expenses easily because loan payments are fixed and do not fluctuate.

Cons of debt financing

·         You need to repay the loan on schedule whether your business is performing well or not

·         Having to repay loans monthly may limit business growth.

·         Lenders (banks) may require a lot of things from you to access the loan, like collateral and credit history amongst others.

 Key Differences Between Equity and Debt Financing

How to Decide Between Equity and Debt Financing

The right financing option for your business depends on your personal risk appetite, growth stage and business goals. Here are a couple of things for you to consider:

When to choose equity financing:

·         You have little revenue but high growth potential

·         You don’t have the necessary requirements (like collateral) to obtain a loan

·         You would benefit from the mentorship and networking connections that investors have to offer.

 When to choose debt financing:

·         You want to retain full ownership and control over your business

·         You have consistent cash flow to make loan payments

·         You want short-term funding and you have a clear repayment plan.

 Mixing both equity and debt financing

It is not uncommon for businesses to use both equity and debt financing to service their need for capital. A company may decide to use equity financing to fund expansion and debt financing for short-term cash flow needs at a ratio that keeps the company attractive to lending institutions in case of future loan applications.

Two Real-World Examples of Companies that use Equity and Debt Financing

1.   Equity financing: Paystack

Paystack raised over $1 million in funding from investors and was later acquired by Stripe for $200 million. They used equity financing to scale operations without the pressure of loan repayment.

2.   Debt Financing: Dangote Group

The Dangote Group obtains loans to the tune of billions of dollars to carry out expansion projects without giving up equity.

 Common Mistakes Businesses Make When Seeking Financing

·         Taking on excessive debt without a clear repayment plan

·         Giving investors too much equity early on

·         Not having a proper understanding of investors’ expectations

·         Ignoring loan terms and having to eventually pay more interest than necessary

Conclusion

Knowing the differences between equity financing and debt financing will go a long way in shaping the future of your business as a Nigerian entrepreneur. It all depends on the needs of your business, your risk tolerance, and your growth strategy. It is important to also seek expert financial advice so that you make the best decision and avoid costly mistakes.

Which financing model do you prefer for your business? Share your thoughts in the comments.