Quora Answer: Is a Loan or Equity Funding Better for Startups?

The following is my answer to a Quora question: “Between a loan and equity funding, which is better for startups?” 

That depends on the requirements of the founders, and the underlying financials of the company.  There are actually three options here: loan, equity, and loan to equity.  They have different implications. 

A loan means the balance sheet is loaded with debt.  This may have an effect on the company’s credit, and will be a consideration in future rounds of funding, since there is a stress on the cashflow.  Revenue is projected but the repayment is definite.  A loan does have the advantage in that no equity is given out, and the capitalisation table is preserved.  There are less complications in managing the capitalisation table across future rounds of funding. 

An equity stake means that the funder is now a shareholder of the business,  While there is no guaranteed cost in the form of loan repayment, the equity given out diminishes the authority of the founders.  A major shareholder can also demand a seat on the board, and interfere in the running of the business.  If too much equity is given out, founders may lose control of the company, and be unseated from the board.  Any equity given out cannot simply be taken back.  It also complicates the capitalisation table in future rounds of funding. 

A loan to equity is when a loan is given to the business, with the understanding that it can be converted into an equity stake in the future, dependent on conditions specified in the contract.  This is when the funder is hedging his bets.  Such options normally disadvantage the founders. 

Generally, for startups, it is best to give our some equity early.  The valuation of that stake given out should take into consideration future rounds of funding.  Any stake given out for this first round should never be more than the stake the founders control.  A loan is something that can be taken on after the first round of funding, to address immediate cashflow needs, while preserving equity in preparation for the next round of funding.  A loan to equity is only considered under special circumstances.  It is seldom palatable.