Flavors of Capital: Debt, Equity, Grants

All capital that goes into an organization is either grants, debt or equity. It’s important to understand the differences between the three because they are very different animals. 

Grants are largely associated with nonprofits and social ventures (see Chapter 11). A nonprofit working to alleviate poverty in East Africa might get a grant from the Gates Foundation to improve their distribution infrastructure, for example. Sometimes for-profit companies may qualify for government grants as well. Many state and local agencies provide grants to help small businesses grow in a way that helps local economies and employment. The distinguishing characteristic of a grant is that there is no expectation of it being paid back. It’s not exactly free money because often there are a variety of strings attached to it, but it is neither debt nor equity on your financial statements.  

Debt is an easy concept for anyone with a bank loan or a credit card to understand. If a company borrows money, they have an obligation to repay the lender—principal plus interest—incrementally over a specified amount of time. The lender has no claim to any ownership of the company nor to any future company profits beyond repayment of principal plus interest. 

Equity is sort of the opposite of debt. An equity holder has claim to a percentage ownership of the company and a percentage share of all its future profits but no claim to any repayment of the capital they invested. When a venture capitalist invests in return for twenty-percent equity, there is no repayment obligation, but they now own twenty percent of your company and a claim to twenty percent of all its future profits. The reason they invested is not because they expect you to pay the moneyback but because, when you sell the company for a billion dollars, they will get twenty percent of the money!

Debt vs Equity, Pros and Cons

Your parents probably told you that debt is evil and you should avoid it. They’re not wrong, of course, but for companies debt is actually cheaper than equity. 

Say you had one source of capital offering you five hundred thousand dollars in debt financing at a six-percent interest rate amortized over five years. You also have another source of capital whispering in your ear, “Don’t take that! I’ll give you the same amount, but I’ll structure it as twenty percent of your company’s equity—no loan payments at all!”

Before you choose which one sounds better, let’s look at the math. The debt capital will cost you $79,984 in interest, spread over five years (and that interest is fully tax deductible for the company to the extent it offsets earnings). If you think $79,984 is more expensive than twenty percent of all the company’s future profits and equity, then I have some pretty serious concerns about your expectations for the venture.

The problem, of course, is that most startups don’t have the creditworthiness to get the loan, nor do they have the cash flow to service the debt. That’s why the venture capital industry was created: to make a ton of money from equity financing for companies that can’t qualify for debt financing.

You may end up choosing equity financing for your startup, but don’t fool yourself into thinking it’s a better economic deal than debt financing; it’s probably not.