We are often asked if it is better to raise finance with a loan, or by giving away equity in your business, so we thought we would outline the key things to consider. We know the world has changed dramatically in the past few weeks and this is quite a dry subject but it’s worth delving in to – so please bear with us.
Most businesses in the world have a balance of equity or debt but why and what does that actually mean?
Equity is a share in your company. If you raise finance by giving away equity, you are receiving money from an investor, in exchange for a share in your company. Equity investors are taking a big risk because they will only make a return if your company does well ie. you are bought or exit through an IPO (I’d always aim for the former!).
Debt is a loan, whereby someone lends you money and you have to pay it back. Often it comes at a cost (called interest) where you have to make a monthly payment for a period of time. At times it comes with other terms and conditions, but the key thing is that you’re never giving away any part of your company. It’s important not to take on too much debt but in moderation it makes a lot of sense.
Neither are good or bad, and there are times to raise money by giving away equity, and other times, when debt is the right answer.
The real debate is what do you need the money for? Depending on the use of funds, you need to think about which type of finance is best for your business.
For instance, if you are at a very early stage, and need to hire a tech team to build a product, the risk is very high. You are unlikely to be generating revenues, and it is hard to forecast when and what the economic benefit will be. Professional equity investors will understand the risks, and will take a longer term horizon before expecting a return. They are very good at being patient, evaluating business plans and helping you along the way. It is for this reason that they require a share in the business, as their capital is being put to work in a risky venture (hence the term Venture Capital).
On the other hand, there are times when debt is the answer
This is when the cash flow and returns, of any given project, are much easier to forecast. A debt investor wants to know that if they give you £1,000, that they will get it back. Yes – they want to be paid interest, but they must be confident their money is eventually coming back. This is why User Acquisition (UA) spend is more suited to debt, because it is trackable and forecast-able (is that even a word?).
Let’s assume you spend £100,000 per month on UA (already a big number!), and let’s assume that you acquire users for £1, and their LTV (lifetime value) is £1.25 after 4 months. As a studio you would probably love to buy as many similar users as possible – because they’re profitable. This means that after under four months, you break even on the money spent to acquire these users. If you use equity to fund this, then you give away a share of your business forever, and you dilute existing shareholders.
But if you debt fund it, then you borrow the money now, buy the users, pay some interest, and within four months it is paid back. You have the same equity as before, and you can scale the money up and down as you see fit. You have more flexibility and the cost to your business is lower. This brings us on to our next point.
What’s the cost of equity and debt funding?
Well that really varies. The cost of equity depends on how much you’re raising, at what valuation, and what the investor wants. Typically (and we’re generalising here) each equity round is about 10-25% of the business ie. if your business is valued at £8m, and you need to raise £2m, then your post money valuation is £10m, and you have given away 20% of the business to investors.
The cost of debt is the interest that a lender is charging in return for their money. To put this in perspective, a mortgage might cost 2-4% per year, an overdraft 15%, a credit card 20%, and an unsecured loan 50-70%. Clearly, the higher the cost, the harder it is to justify, but if you can find the right loan, from the right people, at a sensible one off price, then debt funding UA makes a tonne of sense.
Sugar can help you debt fund your business, to help you better manage your cashflow, where it makes sense. If you want to scale up quickly, just add sugar and drop us a line at firstname.lastname@example.org