If you’re wondering when to use debt or equity financing, you may be dealing with the following dilemmas:
To help you decide when it makes sense to use debt vs equity financing, we interviewed Matt Hafemeister, former partner at a16z and currently Head of Jeeves Growth, who shares his insights and reveals when it makes sense to use one, the other or both types of financing.
In this post, we’ll cover:
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It may be difficult to know when to use one or the other because debt and equity financing are evolving.
Since the start of 2022, equity is harder to come by. Equity investors and venture capitalists are more selective than before and months can go by before they reach a decision or deploy funds. You also risk receiving low valuations and underselling your shares in a more discerning market.
On the other hand, digital debt lenders are making it easier to access debt. Traditional financial institutions will want to see debt instruments like a business plan, a credit score and personal guarantees and will take weeks or months before coming to a time-consuming decision.
Instead, digital debt providers will base decisions on your ability to pay them back by looking at your cash flow and revenue. With digital term loans, you can receive funding in a few days.
Now that you know how these changes can affect your funding, here are Matt’s suggestions on when it’s better to use equity or debt financing:
One important aspect business owners often overlook when considering debt vs equity financing is that investors are underwriting massively scalable companies. So, if your goal is venture scale, focus on equity through venture capital.
“Venture scale is very different from building a company. It means you take on a huge amount of money, hire people, burn a lot of cash, and get to that next stage as soon as possible. So equity is well suited for companies and entrepreneurs that want to get really big really fast.” – Matt Hafemeister, Head of Jeeves Growth
In addition to venture scale, you can also use equity funding when you:
“Not everyone wants to build venture scale. Debt is a great alternative for businesses that are thinking about fundamentals, like profitability and cash flow generation.” – Matt Hafemeister, Head of Jeeves Growth
If you don’t have a blue ocean strategy and don’t plan to be a disruptive company like Uber, Airbnb or Netflix, then choose debt financing.
You can use debt financing for both short and long-term solutions to become profitable and build your business.
For example, you can use short-term capital funding to pay for supplies or inventory so you can generate cash flow early on without diluting your future profits.
Long-term debt funding can help when you have large investments such as acquisitions and new country launches or important assets to purchase like machinery and real estate.
You can also use debt financing when you:
“When equity is really hard to come by, you can turn to debt and start thinking about capitalising your business. You can start to raise funds, extend your runway, leverage your balance sheet, leverage your revenue, leverage your customers to get more capital to then invest in those growth businesses without touching your core cash revenue and your core cash runway.” – Matt Hafemeister, Head of Jeeves Growth
If you rely too much on one type of financing, you can lose your business or go bankrupt.
Let’s take overzealous equity-financed companies like DoorDash and Uber as examples. The founders of DoorDash only owned 2% of their company by the time it went public. And investor pressure eventually forced Travis Kalanick out of Uber.
By using a balance of both types of financing, you can mitigate the risks of equity dilution and reduced control and take advantage of digital debt’s flexibility and speed.
Up until recently, early-stage companies haven’t had the same luxury as more mature businesses and could only count on equity.
Today, you have more options available on how to grow your company thanks to alternatives like venture debt and to digital debt lenders.
An ideal time to use both equity and debt is when you’re about to raise an equity round. When you just raise, it’s easier to take out debt because you can leverage your cash flow and provide stronger guarantees to debt lenders.
Matt also suggests to start using debt and equity together as soon as you can to create an optimal capital structure for your business.
“If you look at big companies like Apple or Amazon, their capital structure is a combination of equity and debt. They raised equity, went public, and raised new rounds, but they also have debt. And because they are low-risk businesses, they can pick and choose. Sometimes they do stock offerings, other times they raise debt. They can figure out which one they need for efficient capitalisation.” – Matt Hafemeister, Head of Jeeves Growth
Matt says to use equity first until you start to grow. Once you have the predictability of cash flow, stable revenue, and assets on your balance sheet, you can use these as leverage to access debt financing and create your optimal capital structure right away.
Considering venture debt as an alternative? Find out what venture debt is and if it's the right type of financing for you.
When you use debt or equity financing depends on your business, the stage of your company, growth speed, and a variety of factors. Each company is different, so each founder’s needs will differ.
We hope our insights help you find the best financing option for you and your business.
If you’re a growing business looking for a financial operating system, try Jeeves.