Equity or debt funding? How to decide


Startups seeking funding are often unaware of the pros and cons associated with asking for too much or too little, and whether to consider debt or equity funding, according to Gerrie van Biljon, executive director at South African SME risk financier Business Partners.

Van Biljon warned entrepreneurs to be cautious of the amount of finance they apply for, as the wrong amount could jeopardise the success of their business.

While applying for too little funding may not satisfy the financial needs of the startup, securing more funding than necessary puts additional pressure on cash flow.

“This debt needs to be repaid to the lender, and the more debt the business is in, the higher the repayment will be,” he said.

Van Biljon said there is also the risk of the business owner being tempted to utilise the additional funds for private use.

“Obtaining too much money could lead to the improper use of the additional funds suddenly becoming available to the business owner. This money is also very likely to be spent on unnecessary items that will not necessarily improve the position of the business,” he said.

Asking for too much funding can also have a negative impact on an entrepreneur’s approval rate for finance.

“Should an entrepreneur apply for an amount that the financier believes is unjustified, the possibility exists that the application will be rejected. This could be for a few reasons, such as the financier not being confident that the entrepreneur is familiar with his/her financial position and the needs of the business, or that the applicant is not fully transparent on the proposed application of funds,” van Biljon said.

The financial requirements of a startup stem from either its current position, or the proposed plans for the business, taking into account expansion, increasing capacity, acquisitions or capital to develop a new product range.

“When applying for finance, an entrepreneur should be very clear on the position and strategy of the business as this will determine what type of funding is appropriate for the business. For example – is short or long term finance more suitable or should the finance be in the form of debt or equity,” said van Biljon.

When you bring an investor into your business this usually implies that equity will be introduced and that the investor will obtain a shareholding in the business. Although this format of funding has the advantage of no fixed repayment terms, in the process the entrepreneur parts with a portion of ownership of their business.

“When opting to go with this finance option, selecting an investor should be done with caution, and both parties should agree on what their expectations are,” van Biljon said.

He cautioned businesses with high growth potential regarding taking more funding that what is required.

“Investors may offer the entrepreneur more funding than what is required, which will result in the investor obtaining a larger shareholding in the business. Introducing this equity may be a very expensive exercise should the entrepreneur decide to buy the investors’ shares at a later stage, as this figure could be inflated due to the growth that the company has experienced,” he said.

Although entrepreneurs may be tempted to spend additional funds, van Biljon said they need to understand the potentially dangerous long-term effects of this. He said instead they should carefully allocate funding to items that will grow the business.

“During the process of establishing what type of funding is appropriate, professional advice is recommended as not all entrepreneurs are financially orientated or familiar with the financial principles. Sound, professional advice will guide and steer the entrepreneur to the most suited solution for their particular needs,” he said.

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Passionate about the vibrant tech startups scene in Africa, Tom can usually be found sniffing out the continent's most exciting new companies and entrepreneurs, funding rounds and any other developments within the growing ecosystem.

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