Debt vs equity financing: What's best for your startup?

One of the most critical decisions you’ll face when launching or scaling a startup is how to fund your venture. Most founders choose between debt or equity financing (rather than slow-burn bootstrapping), but each option offers distinct advantages and challenges.

Debt financing involves borrowing funds that must be paid back over time, typically with interest—however, the lender has no control over your business operations. Equity financing, on the other hand, involves raising capital by selling shares of your company. This means investors provide funds in exchange for ownership interest, potentially having a say in business decisions.

Choosing between debt vs equity financing goes beyond financial implications—it’s a strategic decision that can affect every aspect of your business, including:

• Control
• Ownership
• Financial health
• Company culture
• Growth trajectory
• Investor relations
• Exit strategy
• Risk profile
• Tax implications

While it’s usually a short-term financing solution, your choice should align with your long-term vision. Below, we’ll walk you through everything you need to know about debt financing and equity financing to help you make the best choice for your startup.

What is debt financing?

Debt financing involves borrowing a fixed sum from a lender, which is then paid back with interest over a predetermined period. This option doesn’t include selling any ownership stakes in the company. For startups, this can mean a bank loan, credit lines, merchant cash advances (MCAs), or bonds.

Debt financing, like small business loans, can be a great funding solution for startups with clear and predictable revenue streams that don’t want to dilute ownership in their company. However, you’ll often need high-value assets or a top-notch business credit score to earn favorable sums, terms, and rates.

Pros and cons of debt financing for startups

Pros:

• Retain complete control and ownership of the company
• Interest payments are tax-deductible
• Once the debt is repaid, the financial obligation to the lender ends

Cons:

• Regular monthly payments can strain cash flow, especially for startups without consistent revenue
• Debt can be difficult to obtain for startups without a solid track record or collateral
• Failure to repay can lead to bankruptcy or loss of assets

What is equity financing?

Equity financing is the process of raising capital through the sale of shares in the company. This means investors fund the startup in exchange for ownership interest or stock. This type of financing is common in early-stage startups and venture capital deals.

Equity financing might be the right funding instrument for your startup if you need significant capital but don’t want the pressure of immediate repayment. It’s also helpful when you want to bring on mentors and strategic partners to leverage their knowledge and connections.

Pros and cons of equity financing for startups

Pros:

• No obligation to repay the funds, which can reduce financial pressure
• Access to investors’ expertise, networks, and additional resources
• Better suited for startups with high growth potential but without immediate revenues
• Accessible even without assets or a proven track record

Cons:

• Dilution of ownership can lead to loss of control over business decisions
• Potential for conflict with investors who may have different visions for the company
• The fundraising process can be time-consuming and complex
• Debt gets repaid, but equity is lost forever

Debt vs equity financing: A direct comparisons

American investor Mark Cuban says, "The more of your equity that you can retain and control, the more the upside…People get this mindset that, 'OK, I’m starting a business. Now, I’ve got to go raise money. “Just remember raising money, whether it’s from me, on ‘Shark Tank’ [or] anywhere, that’s an obligation. There’s somebody who wants that money back.”

That’s true of both debt and equity financing.

Let’s take a closer side-by-side look for you to better understand the differences and similarities between equity and debt financing:

Control and ownership

Debt financing is often preferred by founders and small business owners who wish to maintain full control over their startup’s direction and operations. However, lenders may impose covenants or restrictions that can influence your business decisions.

On the other hand, equity financing involves exchanging a portion of ownership for capital, bringing on investors who may demand a say in company decisions. This could potentially lead to conflicts if their vision differs from that of your own.

Cash flow and profitability

With debt financing, your startup faces the challenge of managing cash flows to meet repayment schedules, which can be particularly difficult during the early stages when revenue streams might not be fully established. This can lead to a focus on short-term financial management rather than long-term strategic growth.

Equity financing doesn’t impose loan payment obligations, allowing your startup to use more resources for growth and expansions. However, the cost comes later in the form of diluted earnings per share and potential pressure from investors to deliver returns.

Long-term financial implications

Debt financing can be a double-edged sword—it allows for growth without diluting equity but also adds a fixed expense that can drain resources (if not managed properly). A high debt load can limit future borrowing capacity and may hinder flexibility in operations.

Equity financing eliminates debt-related pressures but can lead to reduced individual control over the business. Plus, you’ll likely receive lower personal gains (relatively) if the company’s valuation significantly increases over time.

Risk assessment

Choosing debt financing exposes a startup to financial risk, particularly if the business encounters unforeseen challenges that affect its ability to repay the debt. This can lead to increased financial leverage, magnifying gains and losses.

Unlike debt financing, equity financing mitigates the risk of default since there’s no obligation to return the investors’ money in the case of business failure. However, it introduces the risk of investor influence, which can shift the company’s trajectory and affect its culture and founding principles.

Factors to consider when choosing between debt and equity

The choice between debt and equity financing isn’t a one-size-fits-all answer. Your startup, industry, experience, connections, financials, and growth trajectory will all play a part in finding the best funding option.

And what’s right for one startup might be wrong for another. And what’s better for your first venture might be worse for your second.

Here are some factors to consider to help you narrow down your options:

• Current financial health: Evaluate if steady revenue and credit history favor debt financing or if an early-stage profile leans towards equity without immediate repayment pressures.
• Growth stage and future funding needs: Consider whether rapid expansion for early-stage startups suits equity financing or if predictable cash flows for established ones make debt a better fit for targeted growth.
• Market conditions and economic climate: The broader economic environment can affect the cost and terms of financing. For example, in a low-interest-rate environment, debt might be cheaper, while in a bullish market, there might be more appetite for equity investment.
• Strategic goals and vision: Align financing choices with your long-term goals, whether that’s maintaining control with debt or scaling quickly with equity. Also, consider your risk tolerance—you don’t want your decision to keep you up at night.
• Impact on company culture and operations: Debt financing typically doesn’t involve giving up board seats or significant influence over company decisions, whereas equity investors may want a say in operations and strategy.

Real-world financing examples

Looking at the startup ecosystem over the last decade, you’ll find plenty of businesses that succeeded with various financing strategies. Some relied entirely on loans, while others immediately turned to venture capitalists and angel investors.

And others still relied on their own money and savings (like Webflow) to turn their business ideas into reality.

Debt financing examples:

• Tesla: Tesla has used debt financing to fund its operations and expansion plans. They’ve issued convertible notes and taken on debt to finance the construction of their gigafactories.
• Spotify: Before going public, Spotify used convertible debt in a deal with investors that would convert into shares upon an IPO.

Equity financing examples:

• Facebook: In its early stages, Facebook raised capital through equity financing from venture capitalists and angel investors, including a well-known $500,000 investment from Peter Thiel.
• Uber: Uber used multiple rounds of equity financing from venture capital firms, private equity, and even high-net-worth individuals to raise capital.

Build scalable infrastructure without a hefty investment

Debt vs equity financing—each option has advantages and potential drawbacks, and the decision ultimately hinges on your startup’s current financial health, growth stage, and long-term strategic goals.

Debt financing can offer the means to grow without diluting ownership, while equity financing can provide valuable resources and partnerships without the pressure of repayment schedules. Remember, the best choice is one that aligns with your startup’s unique circumstances and future aspirations.

Whether you’re bootstrapping or have secured financing, DigitalOcean’s suite of products is designed to support startups at every stage. From Droplets to Kubernetes and managed databases to scalable storage solutions, we provide the tools you need to build a scalable infrastructure without a hefty upfront investment.

Explore our solutions and see how we can help you build, deploy, and scale your applications more efficiently. Your vision, our infrastructure—a partnership (without debt or equity) for startup success.