Should startups borrow or fundraise to expand their businesses? There are pros and cons of both options that should be considered in depth.
The startup journey is a challenging one. There are difficulties at every turn, including getting along with your founders, overcoming lack of demand, ineffective marketing, hiring and a myriad of other obstacles. However, one of the most difficult challenges is making sure the startup has enough cash to stay afloat.
In fact, some may even say that cash flow is more important than profit. To make an idea a reality, a startup will need money to develop an initial idea into a solid product, to hire more employees, seek out experts, invest in production costs and make sure operations run smoothly. To remain competitive, they also need to increase marketing and sales efforts, which will also require substantial investment.
Therefore, it comes as no surprise that many startups fail due to the lack of capital resources. According to CB Insight, it is estimated that 29% of companies fail due to liquidity problems.
So how can startups access funds needed to grow? Two popular channels for funding are borrowing and selling shares. Read on to find out which suits you best!
Debt financing, known colloquially as “borrowing”, refers to a company taking out a loan which it must eventually repay with interest. Debt financing can give startups access to quick capital, which may otherwise take weeks or even months to raise.
Equity funding, also known as “fundraising”, involves receiving capital by selling part of the company’s equity. As a result, your business receives the cash it needs and the investor gets a share of your business. If your business succeeds, your investor stands to gain. Venture capitalists, angel investors and equity crowdfunding are examples of equity funding.
Pros and cons of borrowing vs. fundraising
|Do I have to pay the money back?||Yes||No|
|Do I have to pay any interest on the funds?||Yes||No|
|Will I receive any business guidance?||Usually no||Possibly|
|Will my shareholding be diluted? Will there be many other shareholders on the cap table?||No||Yes|
|Will someone be checking in on my financial health and operations?||Less likely if you are able to return the funds||More likely|
If a startup borrows funds, it will need to repay the debt by a certain deadline. Repayment can happen as a lump sum at the end of the term or at multiple intervals, such as on a monthly basis. This means you will need to keep a close watch on your cash flow to make sure you don’t default when a repayment is due.
On the other hand, with equity funding, you do not have to pay the investor back. Instead, investors are in it with you—if you lose, they lose. If your startup is profitable or grows in value, investors will enjoy the upside of your success.
The interest rate is the percentage that the lender charges the borrower based on their principal. You can think of this as a “fee” that the lender charges the startups for borrowing the money. The interest rate depends on a number of factors, including your relationship with the lender and how likely they believe you are to return the money. Sometimes, high interest rates can make borrowing extremely expensive and unattractive.
For startups that fundraise, they are generally not expected to pay any interest rates
While cash is important for startup success, having the right network and business guidance can be another important factor in growing your business quickly. While not a hard and fast rule, oftentimes, investors are more likely to give you access to their network or guidance since their upside depends on your startup’s success. In fact, some investors may suggest strategic synergies with other businesses that they run or be a great source of advice with a strong business network.
On the other hand, lenders focus on recuperating the capital they provided to the startup with interest. It means that as long as your company isn’t going under, they are not really interested in what you’re doing. This also means they are less likely to go above and beyond to help you grow your business.
Dilution or complicated cap table
In a capitalization table, the equity capitalization of a company is displayed, which includes all forms of equity ownership, such as common equity shares, preferred equity shares and warrants. When it comes to debt funding, your capitalization table doesn’t change. It is a straight-forward loan that you pay back with interest.
However, equity funding means that you will give up part of the company’s ownership in exchange for funds. This may have far-reaching implications. With new investors on the cap table, your interest may be diluted. Dilution happens when a company issues new shares, resulting in a decrease in the company’s ownership of existing shareholders. In other words, with each new investment, your ownership of the company will become smaller (even if your company becomes more valuable). The more shareholders you have, the more complicated your cap table will become.
Scrutiny of company management and finance
Investors will usually scrutinize the startup’s management and financial decisions, such as how effectively money is spent and the cash flow during each period. Since investors only make money if you succeed, and they lose everything if your startup closes shop, it is in their interest to keep careful tabs on your business. That is why it’s not surprising that investors may ask you for frequent updates, quarter financials and meetings.
On the other hand, lenders focus on whether you can return the funds borrowed. As such, they are interested in whether your cash flow can fulfill your obligations to them, but not the other nitty-gritty details of your business.
Whether you should borrow or fundraise depends on a number of factors. Before making the decision, take a long, hard look at what you are looking for and what you have access to. Can you borrow, but only at expensive rates? Do you want business guidance in addition to cash? Do you like having someone scrutinize your decisions and keep you on track? Both methods work, but it will bring about different consequences for your company and future business strategy.
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