The Difference Between Debt and Equity Capital
Angel Squad is platform that helps people learn how to angel invest through education, community, and deal flow.
Recently the squad had the opportunity to invest in a company that is currently raising a debt round.
The startup has already raised an equity round.
So naturally, people in Angel Squad had questions:
1. What is the difference between a debt round and equity round?
2. Why would a founder raise a debt round?
Elizabeth Yin wrote a short blog post addressing these questions. Below is a summary of her points.
What is the difference between debt and equity capital?
Silicon Valley Bank does a great job of explaining how venture debt works. You can read their description here.
In a nutshell... a debt round typically follows an equity round. It doesn't replace equity round.
Founders can raise debt rounds from banks, venture debt firms, and individuals.
The amount and terms of a debt deal will vary from company to company. It depends on things like...
- how much equity the founder has raised so far
- the reason for the debt raise
- the stage and revenue of the company
Probably the biggest difference between debt and equity capital is the payback process.
Generally speaking, founders are not required to repay equity capital. But it's a different story for debt. Entrepreneurs are required to pay back venture debt.
Why would a founder raise a debt round?
Here's Elizabeth's perspective on debt vs. equity:
You take debt when you have strong certainty around future revenue. You raise equity money when there is a lot of uncertainty.
Here are some examples:
- I land a deal with Costco to sell apple pie in their stores. I sell $1 million of apple pie. Costco is going to pay me $1 million in 90 days. But I need the cash now to pay my bakers – I can't wait 90 days.
- I've been running my SaaS company for 2 years. I'm making $20k MRR. I have 2% monthly churn. I have a repeatable sales process and want to hire more SDRs to continue growing.
- I run an electric motorbike company. My bikes are selling like hotcakes! I have a long wait list. But I need more cash to make more bikes. Although I've asked people on the waitlist to put down a $1,000 deposit, it isn't enough money to pay for the full expense of creating more bikes at scale to fulfill all the demand.
In all of these examples, the founder has strong certainty around revenue coming in the door in the near future.
In the first example, it's VERY likely that Costco will pay you.
In the second case, most of your customers will stick around and continue to pay you every month.
In the third case, you have all this demand where consumers are putting down a ton of money for your bikes and seem very committed.
The way to solve this working capital problem is with some form of debt. Borrow money against your Costco accounts receivable. Borrow money against future SaaS revenue. Borrow money against your customer waitlist that is putting $1,000 down for a bike.
Equity is an expensive way to finance these particular problems.
Why? Because you (the entrepreneur) is taking on unnecessary dilution when you just need a bit of capital to unlock a ton of revenue.
Examples where debt financing does NOT make sense
Think about the examples we listed above. Now contrast those with these examples:
- I am building a new kind of hardware system. I'm not sure if it will work.
- I am creating a new SaaS tool but I'm not sure how I will get customers in a repeatable way.
In these cases, it's questionable if a loan would get paid back. Revenue isn't guaranteed or even highly likely. It's high-risk.
This is where equity money makes sense.
The founder doesn't know when she'll figure things out, so she doesn't want terms of a loan hanging over her head.
Plus, no one in their right mind would underwrite these problems with a loan.
Putting it all together
For later stage companies it often makes sense to combine equity and debt capital.
Founders can raise equity money where there is uncertainty. And debt money for fairly certain quick payback.
Let's consider the startup that pitched to Angel Squad.
This company has enough equity money to last nearly 2 years, and they'll earn additional revenue from a large contract they just signed.
But it doesn't make sense for them to dip into their equity funds, because the payback on their overhead will be so quick.
Raising a debt round will help them execute on their new contract as quickly as possible.
This is important – the quicker they execute on their contract, the quicker they can make money.
Waiting around to deploy the contract slowly is an opportunity cost for them.
So this debt round will give them capital they need to realize revenue without draining their runway.
If you're interested in wrapping your head around this more, Elizabeth highly recommends reading Shoe Dog, by Phil Knight.
Shoe Dog is the story about Nike. The book centers around how the team struggled to find working capital to fulfill customer demand.
They needed cash to make shoes.
But the more shoes they sold, the more capital they needed, which was hard to get.
Demand for Nike's shoes was super high, but they had a hard time getting the capital to fulfill these orders. They struggled to find a bank who would lend them money.
Believe it or not, the debt market for startups is more or less the same as what Shoe Dog faced in the 1970s – banks don't loan to startups who don't have many years of credit history.
So most startup loans still come from family and friends.
In Elizabeth's words:
"I often think the VC world is pre-historic, but the debt world for startups is way WORSE and needs disrupting. (Just my $0.02)."
Kera from Hustle Fund