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Factors to consider when taking debt vs equity
Here’s the problem: Your startup needs cash to grow. You’ve got some revenue, you’re not profitable yet, but you think your prospects for the future are great. You’ve put everything you have in the business. You’re looking for equity funding of $150,000, but investors want to lend it instead. They are not prepared to be shareholders. Thus far, you’ve managed to remain debt-free. If you accept the terms, that’s all going to change.
What should you do?
This is a predicament that entrepreneurs often find themselves in. On the one hand, they want the capital. On the other, they fear being drowned in loans. As well, making regular interest payments can cut into their company’s cash flow.
Your decision-making process will likely be governed by math. First, will you be able to afford the interest payments? Second, will you be able to repay the debt when it comes due?
If the answers to those two questions are an easy “yes,” then borrowing money might actually be better than selling equity in the company. Lenders don’t have the same access to a business as shareholders do. They can’t normally vote or even ask too many questions after funding is complete. As long as you honor the terms of your agreement, lenders have to leave you alone. Borrowing might be cheaper and less cumbersome.
But many business owners fail to contemplate some of the finer details of a loan proposal. This can be problematic.
For example, it’s quite common for venture lenders to issue “on-demand” loans. These are debts that can be called in at any time and for any reason by the creditor. They are designed to protect the lender if the borrower encounters financial difficulty. A business may keep a loan facility in good standing but could otherwise be diving nose-first into the ground. The lender would be able to demand immediate repayment and bolster the chances of getting its money back before the company collapses.
However, on-demand loans can destroy a business if they’re called in at a bad time. Imagine having to repay $150,000 with just a month’s notice! They can also be used by the lender as leverage, either explicitly or implicitly. An ruthless creditor might demand a paid seat on the board of directors, or else…
Loans can also come with all sorts of tripwires. Even if they are not payable on demand, they might include clauses that effectively make them so. For example, a debt agreement might require a business to maintain a certain amount of monthly revenue, or else it can be called in. One rough patch could allow the lender to demand instant repayment. That could cause a snowball of unfortunate events.
Further, some loan contracts can make dispute resolution challenging. They may call for arbitration rather than being settled by a court of competent jurisdiction. This often puts the lender at an advantage, especially if its pockets are deep.
Other times, they may set litigation in a location that can be logistically difficult for the borrower. In my case, I always require legal action to take place in Vancouver (where I live and work) or in a city where I have a lawyer. After lending money, I don’t want to risk bearing the expense of litigating on the other side of the country.
Therefore, deciding whether to borrow in order to fund your startup is a calculation that requires more than just mathematics. You should assess the loan agreement carefully and understand your rights and obligations thereunder. I always recommend discussing with a lawyer first, even if you feel confident in the stipulations of the offer. Borrowing money can be a great way to capitalize your start-up. But the wrong loan product can burden you with an excessive level of risk.
Alexis Assadi is the Chief Executive Officer of Pacific Income Capital Corporation, a firm that provides funding to entrepreneurs, real estate managers and business owners. As an investor, one of his aims is to work around obstacles that may otherwise preclude traditional financiers, such as banks, from accepting a deal. You can connect with Alexis on LinkedIn or elsewhere on social media.