NVTC is inviting members and industry leaders to serve as guest bloggers, sharing insights and information on trends or business issues relevant to other members. In his latest post on the NVTC blog, Matt Rajput of CohnReznick shares his the pros and cons on equity versus debt financing.
Even though there are many sources of capital in today’s market—commercial banks, investment banks, private equity, venture capital, angel investors, mezzanine lenders, crowdfunding, and IPOs—there are generally three forms of financing that technology companies access when they need capital: debt, equity, and a combination of the two. Choosing one form of financing over another is situational. Debt financing may be more appropriate for technology companies with assets to offer as collateral, while equity financing may be more attractive to technology companies in need of both financial and strategic investments.
Debt financing generally requires repayment of the amount borrowed along with interest. However, debt is non-dilutive. This means that if you own 100% of your company before borrowing, you’ll still own 100% of the company after the transaction has been closed. Early stage companies with less of a proven track record, or companies without sufficient assets to offer as collateral, may find debt capital too costly and the covenants too onerous.
Unless company owners have deep pockets, early stage companies may find debt financing to be difficult to obtain as financial professionals typically evaluate the company’s ability to repay its debt through operating cash flow as a condition of the loan. And, as many early stage companies have little or no revenue, this presents too great of a risk to the lender.
Equity financing may be more accessible for growing technology companies. As opposed to debt capital, equity capital is dilutive. Once shareholders consummate the deal, they will transfer all or part of the ownership of the business to the equity investor in exchange for capital. Before an equity transaction can close, buyers and sellers must place a mutually-agreed value on the company, which is usually based on a multiple of actual or projected revenues or operating margin. To obtain the amount of capital that may be needed, a sacrifice of a substantial amount of ownership rights may be required. The upside is that the right investor can introduce operational and strategic resources in addition to financial resources, and this can be a major advantage. A key part of raising equity capital is to find the right investors who have industry experience and acumen, as well as connections, to help grow and improve the business.
Other alternatives exist that offer a combination of debt and equity, such as convertible debt. This alternative begins as debt, but can be exchanged for ownership interests in the company if certain milestones are achieved. Lenders may also request stock warrants or other “sweeteners” in conjunction with issuing debt, so that they can benefit from an eventual sale.
Among other things, lenders or investors want to be sure that technology company owners are committed to the project, they’ve got some skin in the game, and that they are focused on the success of the company. Although an investor may be very supportive and excited about a specific project or venture, in the end, they expect to either be repaid or realize a return on their investment.
Matt Rajput, CPA, is an Audit Senior Manager with CohnReznick LLP and a member of the firm’s Technology Industry Practice. Working from the firm’s Tysons Corner office, Matt has eight+ years of experience servicing publicly-traded and closely-held companies in the technology sector and he routinely provides services to private equity and venture capital backed companies. Contact Matt at firstname.lastname@example.org. Follow CohnReznick’s Technology Practice on Twitter @CR_TechInd.