Debt vs. equity
It’s a common conversation that many small business bankers will have with a start-up business owner, “I am going to pitch my idea and raise start-up funding, my idea cannot fail.” Stories from earlier days of the Internet .com boom still circulate about a quick 5 minute pitch where a start-up firm was quickly funded and not too long later made the owners very wealthy.
While these stories are great, some seem to miss some key points about;
- What that funding was – equity and the conditions that came with it.
- The concepts of risk and return that go into a transaction like that vs. bank debt
Let’s look quickly at these as a way to make some high level decisions about searching for equity vs. debt financing for your small business.
Equity and its conditions:
Equity funding is nice in that it:
- Has generally longer term in nature
- Has no repayment requirements
- Does not involve your personal finances
- Depending on the source, may come with advice and share support for your firm
Most of the time equity funding does require you to give up significant ownership in your firm.
You will share the risk of your firm being unsuccessful by giving ownership and the right to returns your firm makes to others. This fact is often poorly understood by those looking for start-up funds, especially the amount of ownership they will need to give up for equity funds. TV shows like “Shark Tank” are really helping to show the true decisions business owners must make around equity investment, but that is a relatively recent though positive trend.
Risk, return and bank debt: Although many business owners feel (as they should) that their idea can’t miss and therefore has little risk, the reality is there are many unknown factors that cause great business start-ups to fail. An equity investor will invest in ten or twenty of these ideas and can afford for all but a couple to fail as long as the equity in the successful ones provide a spectacular return (10x or more). Most business start-ups would not rank their chances of failure at 90%, but the reality that equity investors face is that this is often the case.
A bank debt is an alternative for some firms to raise funding. It is a positive in that:
- No ownership is given up
- A small stream of payments is required to pay the loan back
- Limited reporting is usually required, but no ownership decisions are made
Bank debt does often require the owner’s personal guarantees and the assets of the firm. There is also little tolerance for missed payments, overdrafts or poor financial results. The reason is the bank’s return. If the firm does well the bank makes around 1% profit on the loan amount. If the firm goes out of business the bank will likely lose much, if not all, of their investment (loan). A bank can only be wrong 1 in 200 times or less to stay profitable with these kinds of returns.
Equity and debt are both viable options for any small business to explore. They both have positives and negatives an owner needs to weigh. Understanding who takes on risks and who earns the returns will help clarify why each are structured the way they are. It will also help clarify that mythical story of the “equity” investment that came with no conditions ---- those are called gifts and don’t come from venture capital firms, banks or angel investors.