The Difference Between Debt & Equity Based Crowd Financing
Do you have an innovative idea for a business and need some money to help grow? Or are you considering investing in one of your first startups? There are a few options between equity, debt, and crypto, to raise funds or invest through. I will outline some of the options to what people are leveraging with online investing portals to help you identify what's best for your needs.
At Fund Wisdom we have spent years reviewing innovative investing platforms. These funding solutions give us more insight to what businesses are using for funding sources and how these early decisions impact the future success. Depending on your vision for your business or investment, certain methods of capital will be more appropriate than others.
What Are People Using Today
Below is a screenshot of our dashboard that provides a view of the financing options from our database of equity crowdfunding offerings. These charts show the rate at which others are using each type of financing.
Equity - Sell Ownership
You can raise money by selling a portion of your business to others. Those people will then own shares in your company, and they will expect to receive a portion of company’s retained earnings at a future date. As shareholders, they will have a claim on the company’s assets after the debt holders. They may also require to have say-so in how the company is run by being able to vote according to what portion of the company they own.
The advantage to you is that most shareholders understand that they might not see payback from their investment for years. The importance lies in aligning your new investors to the timeline that you should expect to achieve profit and one day provide them an opportunity to sell their stake to someone else at a much greater price.
If you issue equity, you can choose from a few of these types:
- Common Stock
- Non-Voting
- Class B
- Class A
- Preferred Stock
- Simple Agreement for Future Equity (SAFE)
We will cover SAFEs in the convertible debt section as this is a method of raising money that straddles the line between debt and equity. As you can see from the data this is the most popular choice as of 2023.
Issue Debt - Borrow Money
If you don't want to sell equity, you can rely on debt. Investors give you money under the agreement that you’ll pay them back, plus interest.
The advantage that debt investments tend to be less risky than equity investments, but with lower and more consistent returns. You to retain control of your business. However those who lent you money might require that you back it up with collateral; the risk for you is that if you default on the loan, you could lose those tangible assets. Investors like debt investments because they tend to be less risky than equity investments, and often come with guaranteed cash flows.
If you are considering debt financing a good place to start is with a business credit score. Supermoney and Kapitus offer up competitive rates
. We have affiliate relationships with both. As businesses grow they typically employ a blend of both equity and debt financing to meet their needs. Which method of raising funds works for you? Share in the comments below.
Convertible Debt - Start as a Loan end as Equity
Convertible debt or convertible notes are a hybrid funding mechanism, is essentially a loan which converts into equity at a later date. The holder of the debt can convert the notes into a specified number of shares of common stock in the issuing company. It's a hybrid security with debt and equity-like features. The common form leveraged on most investing portals we cover are Simple Agreement For Equity (SAFEs).
Convertible debt is attractive because it allows startups to delay the need to perform a pricey valuation. How do you measure a startup's value? How do you know their idea or team has potential? It's hard for startups to answer questions like that without any form of established proof. But with convertible debt, startups do not have to answer those questions right away.
Many equity crowdfunding platforms operate a performance-based carried interest model, either alongside transaction fees and fixed costs, or independently of them. Typically, carried interest is charged at 0-10% for platforms prioritizing deal quantity over quality, and up to 20% for models with an imperative on deal quality.
Convertible Debt Success Story
Camperoo raised $600k of convertible debt. Emmie Chang, CEO and Founder of Camperoo, set out to create a company that helps parents discover the best camps for their kids. Emmie Chang said she used convertible debt because "documentation is relatively simple and straightforward. We could also close each investor separately in a rolling close, with some flexibility in valuation caps (which increase over time). It also reduced legal fees and time to sign."
Disadvantages: the first problem is that the risk reward between the seed round and the Series A investors is not reflected in the 20 percent discount. The seed round is much riskier than the next round. A second disadvantage is the nonalignment of incentives between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.
James Geshwiler has written and spoke on this topic on this article as well as Mark Suster, an entrepreneur turned VC, on the pros and cons of convertible debt. Ludwine Dekker, campaign manager at Symbid, wrote about advantages of convertible debt in her article-- Convertible Loans as a Band-Aid Solution to the Valuation Problem in Equity Crowdfunding.
Security Token Offerings - Sell Crypto
A Security Token Offering (STO) is a form of initial coin offering (ICO, or initial coin offering). It’s a type of funding using cryptocurrencies in a regulated fashion. In an STO, cryptocurrency is sold in the form of "tokens" or "coins" to investors in exchange for legal tender or other cryptocurrencies such as Bitcoin, Ethereum, etc. The tokens sold are promoted as future functional units of currency and are done so following SEC-mandated rules. An ICO can be a source of capital for startup companies. Traditional paper-backed assets like equity shares or debts in a business present some transaction and liquidity issues. This type of business funding event in the form of a token can address some of these problems.
As seen from our data a few of the asset categories within crypto are:
- Token Debt Payable by Assets ("DPA")
- SAFT (Simple Agreement for Future Tokens)
The Coinlist platform specializes in STOs and was built by some of the AngelList team. It is a great source to find these ICO investment offerings.
Which one is for you?
The Small Business Administration (SBA) is a government backed program that can help with raising capital and is a great place to start for entrepreneurs. For investors you can view our aggregate of investing portals and performance of each with our investor page. These equity and debt investing platforms are lowering fees and providing better rates. Let us know about your story in the comments below.
