How Can a Founder Compare the Cost of Equity With the Cost of Borrowing?
Short answer. Compare the economic and control effects of each option. Debt brings repayment duties and interest while preserving ownership. Equity avoids scheduled debt payments, shares future value with investors, and may grant them governance rights. Model cash flow under stress, compare terms, and ask your attorney and CPA to review the documents and tax effects.
Compare equity and borrowing by examining the company's cash obligations and the ownership or control it gives up. Debt generally requires repayment and interest. Equity gives an investor a share of future value and may include governance rights. The better fit depends on cash generation, exposure to risk, and the company's growth plan.
Measure the Debt Burden
For borrowing, estimate interest, principal payments, fees, maturity, collateral requirements, and guarantees. Check the covenants too. Test whether the company can make payments if revenue grows more slowly, customers pay late, or costs rise. A debt structure that looks affordable in the base forecast may become difficult if cash flow falls short of plan.
Consider what happens when the loan comes due. The company may need to refinance, repay from cash, or sell assets. Check whether the repayment schedule matches the expected timing of business cash flows. A lender may have remedies if the company misses payments or violates covenants. Review the loan terms with qualified counsel.
Estimate the Equity Cost
For equity, estimate the ownership percentage issued now and consider how later rounds could affect founders and existing shareholders. Account for board representation and approval rights. Other terms may also affect decision making. Equity does not create the same scheduled debt service. Investors share in the company's future returns and may hold rights that influence major decisions.
Compare scenarios at different business outcomes. Avoid relying on a single valuation or forecast. In a strong outcome, the value shared with equity investors may be substantial. In a weaker outcome, debt payments can still burden the company even when growth is limited. Put the assumptions side by side to make the trade-off clear to the leadership team.
Compare Terms and Flexibility
Some businesses can consider a mix of financing. The structure might combine debt and equity, or use a convertible instrument with terms tied to a future event. Each structure changes the company's duties and ownership. It can also affect future financing options. Ask how much flexibility remains if the plan takes longer or requires more capital than expected.
Talk with your attorney about legal duties and security terms. Review covenants with them, along with investor rights. Ask your CPA about tax treatment and accounting consequences. For a broader view, read how to assess debt payments against company cash flow and how to account for future fundraising in ownership plans. The options that can support growth without selling ownership may also be relevant, as can revenue-based financing and the capital call and liquidity planner.
The downside of only investing in the form of debt is that you have limited upside, while an equity investment could grow exponentially.
Sources: The Single Family Office. Informational only, not financial, legal or tax advice.