Well, it’s time to get out of the office and find out someone willing to put some money in your startup. You have been told that there are several sources available but first you have to figure out a simple choice: would you attract funds in the form of debt or in the form of equity?

Type of involvement

First of all, injecting equity usually entails some kind of commitment of the equity provider to the development of the business. Stock holders share the fortune and losses of the startup but at the cost of alienating part of the rights on the generated profits and some control of the business. On the other hand, debt-holders have a strong claim which is way before the payment to equity-holders.
Debt-holders cannot interfere with the management of the company but they care about the periodical payments they have the right to receive. Their claim suffer the same bankruptcy risk of the whole business, however payment to debt-holders are mandatory even without profits and in the event of a bankruptcy they have the first claim on the liquidation value of the assets.

Benefit of risk

Nevertheless, equity-holders are generally better off when volatility is high rather than low. The higher variance of the outcomes usually entails a higher expected value of the claim ex-ante because the downside risk is limited. Put it to the extreme, in a scenario with potentially huge profit as well as losses, the low side of the outcomes is limited to the amount of funds invested in the startup. Equity-holders therefore benefit from increases in volatility since their losses are limited while profits are not. This incentive decreases the risk aversion of equity investors.
Debt-holders face a different situation. Their gain are tied to the agreed interest rate and losses may involve up to the whole face value of the loans. They don’t benefit from more volatility and therefore they are concerned the entrepreneur will take excessive risks. They are not worse off as long as margins are achieved and interests paid. However, at the first sign that you are not going to pay they can take you in bankruptcy court.


With debt you know you are strictly tied to a schedule and you must match that schedule with yours. Not really easy in a thrilling entrepreneurial scenario though! Getting involved with debt has some implications that badly fit the need of flexibility of the entrepreneurial entities. The service to debt holder are rigid and might reduce the scope of actions of the entrepreneur. Equity is indeed more flexible, despite the drawback of sharing the stake with others.
A further argument in favor of equity funding is related to the allocation of risk. Although highly theoretical, the intuition is that equity-holders might better handle the risk involved in the investment than debt-holders do.


More  specifically, since external investors usually have a diversified portfolio, they should not care about the firm specific risk which thus shouldn’t be priced. The VC should require a return that is only related to the exposure of the venture to general market conditions. Even assuming returns higher than that tied to the market on a similar investment, the price demanded by the investors should indeed be lower than the one asked by a non-diversified equity holder as the entrepreneur. Since his private fortune is usually completely linked to the startup, he needs to be compensated. Overall, the cost of capital of the startup will benefit by the diversification of the VCs and the comprehensive value will increase. Debt holder don’t bring such kind of benefit since interest rate is decided ex-ante with regard to the firm entire risk.

Step towards more investments

Nevertheless debt has a different but interesting positive “side effect”. In a signaling game where entrepreneur has to convince third parties to inject some liquidity in the startup, the presence of some loans in the capital structure is a good signal that you trust your company in being able to pay back the interest. You are showing that your commitment is genuine and that you believe prefixed performance targets can be achieved. Debt can be a mean to attain more funds from VCs. You are not trying to convince them with cheap talk, brilliant market growth or letters of intent from potential customers. You are convincing them with a strong commitment, a commitment that can lead you to bankruptcy.

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But watch out before getting tied to interest payments: some debt is good, but when it’s way too much for a still unstable firm, then not only you are closer to default but you also fail to attract VCs. This is the typical tradeoff of corporate finance theory about the optimal level of debt and it partially applies to startups.

Without going too far into details, I believe this is basically the kind of thought an entrepreneur should take into consideration in the very early stages of its venture. Debt might offer some help in the search for VCs funding but as a whole it doesn’t really fit within the startup world.

Follow up questions:
–  What are the different kinds of financing sources?
–  How to match startup flexibility with financing operations?
–  What are preferred equity, call options/warrants and convertible debt and what are their advantages?
–  What are the positive and negative signals that affect the VC investment?