Debt Funding Vs Equity Funding: What Should Startups Choose While Raising Capital
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Fundraising is an indispensable part of start-up entrepreneurship. A common dilemma that besets the founders is that of choosing between debt financing and equity financing while raising funds.
What are Debt Financing and Equity Financing?
At a fundamental level, debt financing refers to raising funds vis-a-vis debt. Raising funding via debt has its fair share of pros and cons. Startups raise funds through debt funding from investors with the assurance of repayment with added interest. While one’s ownership remains intact, a lot of assets can be at stake as collateral.
Equity financing, on the other hand, is just the opposite. It is the process of raising capital through the sale of company shares. The biggest reason why equity financing is considered risky is because the control of the founder or the entrepreneur in his/her startup gets compromised. But it is considered a viable option because one can raise much more capital via this source. Also, the founders are at ease because, simply put, there is no pressure of repayment.
What to choose and when to choose could be, however, difficult to decipher.
Equity Vs Debt
Anuj Bali, founder and CEO of AnBac Advisors, believes that debt funding is always a better idea when utilization of funds is primarily for working capital needs, relevant at transactionally profitable stage. He adds, “Equity investment makes sense where utilization is for innovation, tech building, scaling up, brand building since result turnaround for debt should be shorter compared to Equity.”
Categorizing the needs of your business and its current state will definitely help in making wiser and judicious choices.
According to Yashraj Vakil, CEO of Buzzinga Digital, the choice between using debt or equity funding to raise money depends on your business, the stage it is at, and the founder’s appetite for risk. He said, “Debt funding is always better for founders as they don’t need to part with ownership. Equity funding is great if you aren’t entirely sure about the success of your business. However, remember, you can always raise debt funding to buy back equity you sold at an early stage.''
Ola and Flipkart are good examples to look at the downsides of equity financing. Flipkart founders suffered after Walmart kept increasing its stake in the company. The founders of a cab aggregator unicorn, Ola, were reportedly not happy with the control SoftBank was acquiring after it raised several rounds via equity funding. Flipkart’s co-founders had to ultimately exit while Ola’s co-founder, Bhavish Agarwal, turned down US$1.1 billion deal from the Japanese conglomerate and taken steps to ensure that founders’ control remains safe from any external interference.
Akhil Shahani, managing director of Shahani Group, too, has a simple solution to this dilemma, “If you run an asset light tech-driven company, which has unique intellectual property with proof you can scale rapidly, then you have some chance of raising equity funds. If you don't, like the vast majority of firms, you will have collateral, then debt is the way to go.”
Debt funding seems to be winning among startups. According to a report by data tracking firm, Tracxn, the year 2017 had 27 rounds of venture-debt funding, amounting to US$62.7 million (INR 439 crore), while 2016 had 26 rounds amounting to $58 million. NinjaCart, BigBasket, OYO are some of the notable start-ups that have raised funding from debt.
Apples or Oranges?According to Shubh Bansal, co-founder of Truebil, the choice between debt and equity is like comparing apples and oranges. "Equity or debt holds different value for any business. Equity is used mostly for growth capital, wherein the company wants to grow at a faster rate (to beat the competition or capture the market early). It is also used to finance growth functions, which essentially increases the equity value of a company. Debt is used to fulfill working capital requirements. If a business puts equity capital as working capital, essentially the business is losing free cash flow which can be used to further grow the business."
It is not wise to declare one type of financing preferable over other. India has seen unicorns who have raised funds through debt as well as equity funding. The difference solely lies in the way they are utilized.