5 Reasons to Choose Debt Over Equity Financing
by BJ Lackland, CEO, Lighter Capital, on Apr 3, 2018
When CEOs of early-stage companies think about growth capital, they rarely think of debt financing. Venture capital has a larger mindshare, and a lot of founders are anxious about taking money that has an interest rate or repayment cap attached.
They shouldn’t be. Financing your healthy growing company with debt isn’t the same thing as maxing out your credit cards to fund your product development. You have paying customers, maybe even a few enterprises. You have revenue. You (hopefully) have an accounting function. This infrastructure makes debt easy to account for: you know your repayment obligations ahead of time and you can plan for them.
In addition, debt financing may offer its own hidden benefits. Here are five reasons not to be skittish about financing your company with debt.
1. In the long run, debt is cheaper than equity
Entrepreneurs tend to think of VC as free money. It’s not. In fact, if you plan to scale and exit, debt is almost always the cheaper option.
Think of it this way. If you take a five-year loan of $1M at 20% APR, that $1M has cost you $1.6M by the time you pay it off. But if you take $1M from a VC at a $5M valuation (meaning you sell 20% of your equity), then get acquired for $15M, those VCs get $3M.
The same amount of capital at the same time, but the lender sells you $1M for $1.6M, and the VC sells you $1M for $3M.
2. Debt gives you tax benefits
Assuming your company is out of the red, debt financing provides a few tax perks that equity financing cannot.
If your business uses accrual accounting, the interest portion of your payment runs through your profit and loss statement, which reduces your taxable net income. This means the effective cost of the borrowing is less than the stated rate of interest. Essentially, the US government helps mitigate the cost of your loan.
3. A lender isn’t going to tell you how to run your business
Taking on equity investors means giving them seats on your board. It also means conforming to their expectations of how your company should grow. If you don’t like it, be careful—they can limit your control over the business you started, or, in the worst-case scenario, oust you from your own company.
Lenders don’t worry as long as you’re hitting your payments and staying in a position to continue doing so. No board seats, no control.
4. For businesses with sticky revenue streams, debt can be very accretive
Jason Lemkin points out that if you’re an early-stage company with recurring revenue streams (like SaaS or subscription-based services), a minor amount of debt will actually increase your net cash flows. The extra cash will let you make a few key hires. If you hire well, those folks will build out features and sales programs and you can see an ROI much higher than the cost of their salaries.
5. More time to actually run your company
Raising a VC round usually takes between six and nine months of coffee meetings, pitches, and phone calls. Raising debt financing is generally much faster. Lighter Capital, where I work, often funds companies in one month.
Debt saves you time once you get it, too. Lenders don’t need to keep up with your every decision, and they don’t require board meetings. They won’t need to deliberate with you over every new hire or strategy.
The funding option you pick today will determine what you can and can’t do with your business in the future. It’s important in those early years—after launch and before complete traction—to be aware of all your funding options. Think about where you want your company to be in one, five, or ten years, and think about how much time or control or money you’re willing to give up to get there.