Equity financing or loan? Which to choose for your tech business

What is equity financing?

Equity financing involves raising capital by issuing or selling shares to investors, giving them ownership interest in the company.

Their share of the business varies according to the investment and the valuation of the business. In most cases, the share will be a minority interest, typically between 15% and 40% for a small company.

To allocate a share of the company to investors, the original owners usually issue preferred shares. These differ from the common shares held by the company’s owners. Preferred shares grant certain powers over financial and management matters, such as giving holders priority if the company is dissolved, as well as a veto over hiring and layoffs.

What are the benefits of equity financing?

No repayment obligation

Amounts borrowed under loan financing must be repaid by a certain date. This is the amortization period.

With equity financing there is no repayment obligation, which frees up financial resources and provides a great deal of flexibility. This is particularly beneficial for growing companies, as they can reinvest their liquidity in market development or research and development. This also applies to companies in the pre-revenue stage or whose revenue is uncertain or inadequate.

Better suited for riskier business models

Equity investors are generally willing to take on more risk than lenders.

Equity financing is often the most realistic (and sometimes the only) option for companies with a high-risk business model or maturity level. This is particularly true in tech, where revenue fluctuates, profitability is delayed and tangible assets are limited.

What are the disadvantages of equity financing?

Loss of decision-making control

In exchange for their investment, investors want to have a say in certain strategic decisions such as business direction, key hires or major investments. This means that owners must share decision-making authority.

Investors can also request a more structured governance framework, such as a board of directors.

Mandatory business valuation

To sell an interest in your company, you need to determine its value. That process is complex and time-consuming, as it involves in-depth negotiations with investors. For a small tech start-up with a relatively short track record, valuation can be a real challenge.

What is loan financing?

Loan financing is when funds are raised through loans from financial institutions or other lenders. Your company agrees to repay the loan and pay the cost of borrowing, usually in the form of interest, within a predetermined timeframe.

Various types of loans are available on the market.

Traditional loans with set terms and conditions can be a good fit for many businesses, as they typically require collateral, such as the company’s assets. However, these loans are more rigid and may not suit companies with limited assets, a short track record or an innovative business model, as is often the case in tech.

If this sounds like you, financial institutions (including BDC) offer specialized and customized loans that provide greater flexibility, such as repayment options at maturity.

What are the benefits of a loan?

No ownership dilution

Unlike equity financing, loan financing does not involve selling an interest in the company.

Owners retain full control and ownership while accessing the necessary funds. In practice, this also reduces pressure on owners and operations, as the business does not have to meet external stakeholders’ immediate growth expectations.

Predictable financing costs

The true cost of equity financing is uncertain, as it’s hard to predict how much investors will ultimately earn from selling their shares.

With a loan, however, business owners know up front what it will cost them to finance their project.

That said, loans are generally less expensive than equity financing.

First, the borrowed amount is often tax deductible, which reduces the actual cost of financing. Conversely, dividends paid to shareholders are not deductible.

And while investors typically expect higher returns, since they are taking more risks with no guarantee of repayment, creditors have repayment priority and take less risk, which means a lower cost.

Fast access to funds

Although each situation is unique, it’s usually quicker to get a loan than equity financing, which involves a valuation and negotiation process that can take several months.

What are the disadvantages of a loan?

The amount financed must be repaid by a given date

Borrowing means paying off a loan within a set term. For a tech start-up whose business model is not yet fully developed, this can put pressure on cash flow. The company needs to generate enough revenue to meet the loan payments, even if sales or profitability are still uncertain.

Fixed-date payments also mean that the money will not be reinvested in business development. For a rapidly growing business, this can be a significant opportunity cost.

Equity financing or a loan: Which to choose?

Before you choose between equity financing or a loan, we suggest you consider a few key questions:

What is the maturity level of my business?

Companies that have not yet found the right product for the right market generally benefit from leaning toward equity financing, as they need flexibility to test their business model and support their growth without the pressure of a fixed repayment.

By contrast, if your company has clearly defined its target customer and demonstrated a viable business model, you will be better off with a loan. With more stable revenue, you’ll be able to meet the repayment schedule and enjoy the other benefits of borrowing.

How important is it to retain decision-making control?

Different business owners have different management and leadership priorities. Some want to retain full strategic control, while others are willing to share certain decisions with shareholders in order to obtain funds.

The choice between equity financing or a loan may depend on how much autonomy you want to retain in key decisions. If you want to keep full control of your business, a loan is the best option for you.

What is your vision for the future of your company?

If you are looking to quickly maximize growth, you may prefer equity financing. It offers the flexibility to invest aggressively and take risks, even if it means sharing control and future profits.

If you prefer more stable and sustainable growth and want to build a long-term business, a loan may be a better choice. It removes the pressure of equity financing.

What is the project’s timeline?

It’s generally faster to get a loan than to get equity financing. You should consider your project schedule and the urgency of your funding needs.

If you’re in a hurry, a loan might suit you best. If you have more time to plan fundraising and want longer-term financial flexibility, equity financing may be preferable.

Have you considered hybrid funding?

In some cases, companies can build a hybrid financing solution. You can raise some of your funds in the form of shares and the rest through loans. This approach combines the benefits of both types of funding and is particularly useful when capital needs are high.

Next step

Need advice from experts who can assess your situation in more detail? Contact the BDC Growth and Transition Capital team.