• November 2019
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Equity vs Debt: Your Quick Guide

lawtrades cofounder equity

Stocks or bonds? The answer to this question very much depends on what you are trying to achieve. Are you looking for startup financing, or for a secure investment? What is your time horizon? What is your risk aversion? All of these questions impact the answer to the question: debt or equity? We go through the basics of each, both from the perspective of investor and startup company.

Buying and Selling Stocks: Trading in Company Ownership

A stock issuance is essentially a transaction in company ownership. The company in question sells stock, i.e. shares, which represents a percentage ownership in the company, in exchange for money from the investor.

When it comes to startup financing, investors are almost always offered preferred shares. This means that their shares come with preferential rights: they are protected from dilution, have some liquidity preference, and often also get voting and veto rights with regard to appointments to the board, fundamental transactions, further financing rounds, etc.

The exact content of rights associated with preferred shares is negotiated during the fundraising process. There may or may not be provisions limiting the transferability of the stock as well. That is uncontroversial in most cases: after all, the investor is looking to sell his or her shares at a profit down the line when they are worth much more.

Equity fundraising from the Startup’s Perspective

Selling stock is by far the most common method of startup fundraising in Silicon Valley (except for seed round financing, that is). The advantage: investors prefer buying stock. It gives them more control over their investment, and protects them by way of shareholders’ rights. It also promises more financial reward down the line if the startup succeeds. Long story short: you are much more likely to fundraise successfully by selling stock than you would be with bond financing.

Another significant advantage is that investors who buy stock have vested interests in, and of course ownership of, the company. In most cases, that means that you get more than money from the deal: you get connections, expertise, and mentorship.

Equity financing does come with significant drawbacks as well. It dilutes your own ownership of your company, and limits your control over what the company does and how it is run. Unless your startup is still looking for seed funding, or you are very well established, however, that might be the price you need to pay in order to get funding.

Buying Stock from an Investor’s Perspective

Stock offers significantly higher returns than other investment alternatives. It also poses more risk: if the shares you buy don’t appreciate in value, you alone carry that loss. A large component of that risk is an uncertain, and often long, time horizon. There is no guarantee that the company in question will appreciate in value at the rate that you expect.

In addition to the potential of higher returns, equity investments in the context of startups also provide investors with more rights and oversight over their investment. You will receive preferred shares and shareholder rights, all of which leaves you more “in the loop”, so to speak, than the case would be with bond investments.

Bond Financing: Buying and Selling Debt

In many ways, raising funds through debt (as well as investing in debt) is a simpler endeavor. A company issues a bond at a particular value and with specified terms. The investor provides the money in exchange for the bond, and receives a set amount of interest over the lifetime of the bond. After that, the amount is returned to the investor.

In the context of startup financing, debt finance usually takes the form of convertible notes issued during fundraising in seed rounds. Convertible debt is a way of securing investment in debt form while promising to convert it to equity later (usually upon the next round of funding). In this respect, convertible debt offers the simplicity benefits of a bond, and the equity benefits that investors seek as soon as it converts.

The key to bond financing is the probability that the debt will be repaid at the end of the term, of course. For this reason, it is not a course of action available to startups that are not very well-established. It is therefore very uncommon, though not unheard of: WeWork has previously issued bonds, for example.

Bonds as a source of financing

There are significant advantages to selling bonds rather than stock: you retain ownership of your company, as well as control of management and the board. You are also not granting liquidation and anti-dilution preferences to investors.

The downside is simply that you can’t sell debt to anyone if it is not a sure thing that you will be able to pay it back.

Bonds from the Investor’s Perspective

Bonds offer everything that stock cannot: certainty, predictable income, and a fixed timeline. The price for that? Less return, on average.

As a result, most investors diversify their holdings to include both stocks and bonds.

Whether you are Fundraising or Investing, LawTrades is Here for You

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