Pros and Cons of Tech Financing Options – Debt, Equity and Bootstrapping

For business loan brokers: This guide explains Pros and Cons of Tech Financing Options – Debt, Equity and Bootstrapping through the lens of evaluating a client’s situation, preparing the file, and discussing financing options clearly.

Teammates not competitors

This conversation is often explored as a “Debt versus Equity” debate. I’m not a fan of this debate. I find that the “versus” really misses the point. Equity and debt financing methods are not at odds with each other, they are different financial tools that can be used in different ways and at different times. The same way a hammer and a screwdriver are not at odds with each other.

There is a right time and place for each method of financing. They can even be used together or in various combinations throughout the lifecycle of a venture. In this post, I will look at benefits and setbacks for consideration that come with each financing source.

I’ve made a point of including Bootstrapping in this conversation too, which is not discussed often. The virtues of bootstrapping are well known and (rightfully) celebrated but it is important to discuss and consider the constraints associated with this method of financing a tech company too.

Financing by Raising Equity

Equity is the most well-known way to finance a tech company by far. It includes fundraising from Family and Friends, Crowdsourcing, Angel Investors and Venture Capital.

Pros

1. Patient Capital: Equity investments are incentivized by large exits or liquidity events. When things don’t go according to plan in the short term but the long term vision is still attainable, equity is patient with the company. It can continue to support a company while the company pivots or through difficult economic periods.
2. Early Investment: Equity raises are available to early-stage companies starting with pre-seed Angels, VC’s and family and friends fundraising rounds. It can be used to start the company and to build and create products that cannot be financed in any other way.
3. No Negative Impact on Cash Flow: Equity investors will assume a portion of ownership and are in turn compensated by the companies growth and increasing valuation. There are no payments that take from cash flows.
4. Access to Network and Expertise to Scale fast: Equity investors will often come to the table with additional resources, bring additional expertise to the table or have industry connections that can benefit the company. This is possible from both angel and venture capital investors.

Cons

1. Ownership dilution: Taking on an investor by raising equity requires that a portion of the company is sold which leaves the founders with less of their company.
2. New Partners Opinions may not match Founders: When a new investor is taken on, they may require a board seat to monitor their investment. The new investor’s opinions for the company may not always match those of the founders.
3. Higher overall cost than debt: If the company is growing quickly then the cost of equity is actually much higher than the interest rate on a loan (I’ll explore this cost of capital in detail in a future post).

Financing with Debt

While debt financing is becoming more and more popular (1) it is still considered to be the new kid on the block. Lenders include Banks, Credit Unions, Private Lenders, and more.

Taking a look specifically at Venture debt activity in 2019, there was over $25 billion in lending across 3,066 companies. (1) This might seem like a lot but it is barely scratching the surface. Keep in mind this is only for Venture debt deals for Venture Capital backed companies. There is still a significant amount of loans made to angel-backed or bootstrapped companies too. Still, the trend from the graph shows the rising popularity of this method of financing.

Pros

1. Non-Dilutive: This is by far the number one reason that founders chose to use debt as a tool for financing their company, the capital does not dilute their ownership percentage. (2)
2. Control of management decisions stays with current ownership groups: Control is a very close second reason to use debt. Many founders want to continue to grow with the current ownership group without adding additional partners and just need more capital to do it. This ownership group could already include equity investors or just the original founders.
3. Cheaper overall cost of capital than equity investment: If the companies valuation is increasing year over year, as most startups are, the cost of equity is usually higher than debt (I’ll do a deep dive into this in another post).
4. Ability to end the relationship: If for any reason, including deciding to switch to strictly equity-only financing model, a loan can be repaid. Most loans will likely have a prepayment cost to ending the relationship but it is way easier to drop a debt provider than an equity investor that is on the client’s cap table.

Cons

1. Repayment can Interfere with Growth: Debt will have to be paid back. There may be a principal postponement period, but interest will likely start being paid immediately. When the payments are due the company will need to have sufficient cash flows to support the payments and continue to grow their business.
2. Interest Cost & Fees: Loans will often have fees for set up and security registration as well as an interest cost to be paid on a monthly basis.
3. Requires collateral and covenants: Loans will require security. General Security Agreements, Specific charges on Intellectual Property, Personal Guarantees, Postponements from Shareholders, and more are all potential security that could be required to secure a loan. Some lenders required covenants, which are performance metrics that are monitored.
4. Default Potential: If loan payments are not made, the loan goes into default. This could require credit restructuring and if no reoption is reached, the lender can collect on the security taken.

Bootstrapping

Bootstrapping is financing growth by using a founder’s own funds or reinvesting profits from previous years. Some like to refer to it as funding the client’s company with the client’s revenues. I love this statement because it is simple and true. Bootstrapping involves covering the expenses with the revenues and funding opportunities with what is left.

To be clear, Bootstrapping is actually a form of equity financing. It’s just that the equity is either injected by the owners or created from the profits of the company. I’ve given it its own section to separate it from raising equity as an option.

Pros

1. No Interest Cost: Great.
2. Retain Equity: Amazing.
3. Full decision making control: Even better!

Cons

1. Not always possible: Unfortunately not all companies have the ability to bootstrap. There are significant capital costs related to starting a company and building a competitive product.
2. Can limit Growth: Unless a company is making more money than it can spend, choosing to bootstrap can actually impair decision making by limiting opportunities to cash available.
3. Owners Assume all Capital Risk: The founders have assumed all the capital risk in a bootstrapped business. This risk is not shared with a bank or an equity partner when it could be.
4. Miss out on access to Professional Partners: This one will likely be the most disputed, but there are many examples of investors bringing connections to the table that advance a companies growth significantly. Lenders may also find potential risks in their assessments that had not been noticed. Founders could be missing out on valuable expertise and connections.
5. No Cushion or Insurance for challenges: Depending on how much cash is kept on hand, bootstrapped companies may not have the ability to absorb challenging periods.

Recommendation

It is important to remember that there are success stories with all three methods and with various combinations of the three. Also, each method may have a better use depending on the use of financing and growth stage of the company. For example, I have seen both: Bootstrapped -> Debt -> Venture Capital Raise and also Angel Investment -> VC -> Debt work out successfully for scaling a company (among many other combinations).

A few tips for when the client is looking at each financing option:

• Consider the right option for the client’s company based on the pros and cons weighted to which one is most important to the client’s current ownership group (3).
• Make sure the client use the right financial instrument at the right time and business stage.
• Talk to the client’s financial partners frequently for advice and to be prepared for opportunities.
• Dig into potential investors’ or lenders’ backgrounds before making a commitment to understanding the reputation of who the client is about to partner with.

Footnotes:

(1) Chart from Pitchbook report: Venture Debt Set to Increase Role During Crisis by Kyle Stanford and Van Le

(2) Venture debt may contain warrants in which case this would be minimally-dilutive by comparison to equity.

(3) This includes consulting with existing equity investors.

External Resources:

Check out this article from BDC and Forbes on Debt vs Equity

A calculator for the cost of capital of debt and equity from Lighter Capital

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