David Cummings on Startups

Buy Equity in Your Startup or Loan it Money?

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David Cummings

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Most information on bootstrapping and self-funding a startup revolves around capitalizing the business by buying equity (e.g. you and a cofounder each put in $5,000 to start it). I know one entrepreneur that insists on loaning his business money instead of buying equity in it (after an initial nominal amount).

Here are some ideas on loaning your startup money instead of buying equity:

  • Money loaned is easier to be reimbursed, assuming the business does well, compared to the effort of having the business buy back equity (e.g. it’s easier to get your money back)
  • If other shareholders are involved, it’s easier to decide on a loan interest rate rather than an equity valuation
  • If other shareholders are involved, and a loan is in place, interest on the loan takes precedence over dividends, thereby providing an income stream to the shareholder that loaned the money, in addition to being a more capital efficient option (equity is always considered more expensive than a loan when it comes to what shareholders have to give up)

Loaning money in lieu of buying more equity only makes sense if you’re comfortable with the ownership position (e.g. you own a good percentage of the equity or you don’t want to reduce the incentives of the other shareholders by diluting them too far) and are willing to take on more risk without a requisite increase in possible return.

What else? What are your thoughts on buying equity in your own startup vs loaning it money?

Comments

3 responses to “Buy Equity in Your Startup or Loan it Money?”

  1. Sanford Avatar
    Sanford

    How about a convertible loan? if the company actually survives and is successful, then the loan can be converted to equity via a predetermined formula and that formula would be based on outstanding shares at conversion. i think this would be superior than the traditional series A preferred stock route because in my experience the series A investors ALWAYS get diluted further down the road.

    Reply
    1. Baker Avatar
      Baker

      I think the convertible loan is a good idea. Alternatively, there are ways to protect yourself in the Series A preferred share scenario, either anti-dilution provisions, or dividends that accumulate at a high rate similar to a loan, but are not payable until there is a liquidity event.

      Reply
  2. Dave Williams Avatar
    Dave Williams

    It is interesting as in some businesses, for example nightclub or restaurant businesses the investors get paid out first as that is really where the payback is. In businesses that require investment for later success paying back the money just doesn’t make sense as it is better left in the business in the form of equity. I think this one really depends on the type of business your are investing in.

    Reply

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