Start-up Funding Explained, Part 2

The Difference between Equity and Debt:

Companies aren’t that different from mortgages.  Not many people own their houses out right and not many people want to co-own their homes and split the equity (if any at all in this market) with a co-owner.  The same applies to businesses.

Equity

• Equity is value that can be liquidated and returned to the owners of the company.
• Equity is ownership and can be represented as cash value (ex: $1 million) or as a percentage (ex: I own 10% of a company).

Debt

• Debt is capital that is lent to a company.
• Like most personal debt there are expenses associated with this capital similar to origination and other fees that you would find associated with a mortgage.
• Debt can be paid off, equity cannot.
• Bridge Loans are effective for early stage start-ups and can be executed with angle investors

Mezzanine Debt

• Is debt that acts like equity, Mezzanine lenders also own a percentage of the company that funds are lent to.
• Mezzanine debt, when properly used, can provide all the capital needed to fund an acquisition or buy-out.
• Typically for late stage companies who are profitable.

Misconceptions:
Common misconceptions, especially in the African-American community, is that debt is always bad and equity is always good.  In instances when a company goes bankrupt debt can be good because entities that hold the senior debt holders position get paid first.  This is one reason why it can be risky for entrepreneurs (equity holders – founders and common stock holders) who invest their own capital like we discussed last week in Part 1 of this series.  In instances when a company is successful equity is good because there is a return on investment.

Ideal Situations:
Ideal situations for entrepreneurs are to use both equity and debt as a tool.  A blend of sources of capital is best.

Today’s credit crisis is a great example of why it is best to diversify between equity and debt.  People assume that banks have money when in actuality they borrow money from the Federal Reserve and make money on the money that is borrowed and lent to consumers and businesses.  In current conditions banks can’t borrow money so they can’t lend money and the supply of capital is tight.  Companies who rely on only banks to fund a company end up negatively.  In the case of Lehman Brothers their cash reserve wasn’t able to sustain them through market conditions because their lose was so great.

Tips:

• Entrepreneurs needs sufficient cash reserves to get through a bad cycle until conditions are better, without it you won’t be able to execute on your business model unless you model has extremely low overhead.

• Equity is like virginity you can only give it away once so you want to get the most you can in return.  Don’t sell it all before the company is worth anything and give it away in small increments.

What does small increments really mean?  I had the same question so I asked someone who has played in this realm often, Clarence Wooten of Collective X.  He gave some perspective, “For seed stage start-ups giving away 20% of your company for about $200k is reasonable, however the goal is to increase value in the company with that money when you execute so that in the next round you can ask for double or triple what you asked for initially.”

Thanks to  Robert Greene over at Syncom Venture Partners and Clarence Wooten at CollectiveX who were both kind enough to take time out of their busy schedules to help with developing content for this article and series.

About the Author
Angela Benton is the Founder and Publisher of BlackWeb20.com. Her experience spans a variety of industries including consultative relationships with companies such as UPS, Bizjournals.com, Realestate.com, and Lendingtree.com.
See all posts by Angela.