The Difference Between Debt Financing and Equity Financing

Two Great Financing Solutions — But Which is Right for Your Business?

difference between debt financing and equity financingFor SaaS companies (and indeed many other types of companies), there are a number of options available when it comes to financially enable and supporting growth. Two of the most common sources of funding are venture debt financing and equity-based financing. Each provides specific funding benefits for SaaS companies, but to understand which is right for you, it’s important to first understand the differences between debt financing and equity financing.

Venture debt financing is essentially a loan — similar to that of a bank loan except the terms differ. Whereas a bank loan would require collateral, such as a building, equipment, or other assets, venture debt for SaaS companies doesn’t. Instead, venture debt utilizes intellectual property as collateral. While this might seem like a difficult term to accept, venture debt is actually quite flexible, and a number of mechanisms are in place to ensure you’re able to maintain your obligations, such as covenants.

Similar to equity financing, venture debt takes a partnership approach in ensuring the success of your funding and company. The lender you choose to work with should structure your deal in a way that works with how your company generates revenue, what your short- and long-term goals are, and what your overall financial and business strategy is. But perhaps the most significant difference between debt financing and equity financing is that venture debt doesn’t take an ownership position in your company because equity is not part of the arrangement. This means you retain complete control over the direction of your business at all times.

Equity-based financing is a broad term for a few different funding avenues, such as angel investors, private equity, venture capital, and so on. The difference between debt financing and equity financing here is that funding is provided in exchange for a portion of the stock in your company. This means that the investor would own a stake in your business. For many SaaS companies, this doesn’t pose much of a concern. After all, an investor holding an ownership stake in your business very much so holds a vested interest in your future and will become an integral part of your business to help it achieve its goals.

Because equity financing lenders own a portion of your company and will most likely also occupy a seat on your board of directors, they will have significantly greater involvement in your day-to-day operations. This can be both advantageous and complicated. On one hand, equity investors have a great deal of experience working with SaaS companies and helping them reach their goals. On the other hand, you may have a specific vision that requires certain decisions to be made. With an equity investor aboard, you may have to make periodic concessions in areas such as hiring, using certain tooling or vendors, or in business processes.

While the difference between debt financing and equity financing can be significant, what you decide to do should ultimately come down to what your goals are. Every business needs a strategy to grow, and the choice of financing solution should be part of that strategy. Here, we’ll explore a few goal scenarios to provide you with greater insight into these two financing methods so you can make an informed decision for your growing SaaS company.

Your Goals Govern Your Growth Mechanism

1. Accelerating Growth

If your goal is to take your current rate of growth up a notch, it’s important to be able to do so on your terms. This is why venture debt financing is ideal for accelerating sales and marketing efforts. There are a number of components that go into this, and having the freedom to invest in inbound or outbound marketing strategies while also utilizing the tooling you want to use will be beneficial. And because most venture debt is flexible, as your ROI begins to pick up, you can either take out more of the debt via tranches or pay it back with new revenue.

Equity financing can still work for growth acceleration, particularly because the amount of capital received through an equity arrangement is often higher than venture debt. However, again, the opinion and wishes of any equity investors on your leadership should be considered. This means you may have to use a platform you’re inexperienced with, invest money in a certain strategy that you would have skipped, or hire a salesperson you otherwise might not have considered. While it may take some adaptation on your end, working with an equity partner can also be rewarding and connect you with new people and solutions for growth.

2. Strengthening Financials and Operations

As your SaaS company begins to grow, it will become necessary to strengthen its infrastructure to prepare it for the next step of its journey. Whether that’s expanding platform capabilities, growing your team across departments, or eliminating other financial barriers to progress, action is needed — as is a funding solution. Here, venture debt doesn’t make as much sense. While the resources you gain from the arrangement could be used toward fulfilling these goals, it is still a loan and thus a liability on your budget. It must be repaid according to the terms established in the agreement you sign with your lender. This makes it more inflexible in terms of helping you achieve these goals over the long-term.

This is where the difference between debt financing and equity financing gives an edge to the latter. Equity-based financing will not only provide you with capital to eliminate other investors or obligations and strengthen the infrastructure of your company, but it also connects you with a like-minded partner who has grown companies like yours before with high levels of success. You’ll gain a partner who will be more actively involved in your day-to-day operations and can advise you on everything from financial strategy to operational improvement.

3. Maximizing Your Exit

As the owner of a SaaS company, it’s likely that at some point you’ll want to sell the company to a strategic partner or another individual — ideally providing yourself as the majority shareholder a significant financial benefit when that day comes. While equity-based financing can be used for this and often is, it’s important to understand that because another individual or organization holds an ownership stake in your company, you’ll have to pay them back, too. This means your takeaway as the owner will most likely be lower than with debt financing.

Recently, we explored these two funding avenues side-by-side. In the comparison, we assumed that one company wanted venture debt while another wanted equity financing and that both had the goal of selling after a few years. Time went on and their companies grew. When the day came for the owners of each company to sell, the venture debt loan holder simply had to pay back the obligation with interest. The equity-owned company had to pay back an amount equivalent to the amount of equity given to the investor plus dividends. In the end, the venture debt-backed owner took away nearly $14 million more than the equity investor.

Every Situation is Unique

When it comes down to the difference between debt financing and equity financing, the decision you make should be based on your immediate needs and long-term goals. In some instances, you may be comfortable with giving up a portion of your equity in exchange for capital. In others, it may make more sense to utilize venture debt to grow. But it should first begin with a conversation.

At River SaaS Capital, we offer both venture debt financing and equity financing. This provides you with two solutions from one partner who wants to see you succeed, no matter the avenue you choose to take. Often, our portfolio companies will go one route for their growth goals then return to explore another. But throughout the relationship, River SaaS Capital will be working closely with you to ensure you achieve your goals just as you want to achieve them. Fill out the form below to schedule a time to talk with our investment team.