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When choosing how to finance your startup, the two primary methods are equity financing and debt financing. Each method comes with different advantages and disadvantages, and choosing the correct financing option is crucial to the success of your business.
Equity financing occurs when an angel investor or venture capitalist gains equity stake in a company by providing seed funding. An obvious advantage of this method is the fact that the startup does not immediately go into debt. This being said, equity financing appeals more to those who are risk averse, or those who may not qualify for a loan. With capital invested, the growth of the new company can be the number one priority. With a growing company and no loans to pay off, the opportunities for expansion or new business ventures are within reach.
Debt financing is when you finance your company via bank loan, bond issues, or family and credit card loans, with bank loan being the most common choice. The advantage of debt financing is significant–you retain all shares of your company, allowing you to keep your strategic vision for the company’s direction intact. If you are willing to undertake the risk of accumulating debt and qualify for a loan, debt financing may be the appropriate option.
An important factor when deciding which financing option is optimal for your company is the debt-to-equity ratio. The ratio shows the proportion of financing provided by debt and equity. This is calculated by dividing the total liabilities by the total shareholders’ equity (optimal ratio being 2, but it varies with the size of the company and other factors). A company's balance sheet will have everything needed to calculate the debt-to-equity ratio.
Here is an interesting chart that shows global venture capital funding for the period January through May 2022. As you can see, it has decreased significantly throughout this period, which coincides with the current economic downturn.
While the two methods described above both have their pros and cons, there is no right or wrong answer as to which one you should choose. It is important to make an informed decision based on your company’s status so that your company can start off successful. If you are a founder who is trying to decide which financing method is best for you, contact us for a free consultation.
