Pay now or pay later…
Investments in startups come in two primary forms: debt and equity. These two forms differ on how and when the investors earn back their investment.
Debt
Debt is commonly seen in everyday life in the form of car loans and home mortgages. You borrow a fixed amount of money and promise to pay it back over a specific number of months, in monthly payments, paying interest on the remaining balance of the loan.
$X, repaid with Y% interest for Z months
Debt is commonly used for established companies with significant revenues, but it doesn’t normally work for startups. The problem with debt and startups goes back to the proverbial 10x (see Chapter 12). Early-stage investors are expecting a 2.5x total return, since this is equivalent to twenty percent interest. However, they can’t get that return by charging twenty percent interest, because four of every ten investments fail completely, and another three of each ten return only the initial investment. With that level of failure, investors would have to charge at least 300% interest on their loans, and no startup could afford to pay such interest.
Thus, despite the simplicity of debt, it does not make economic sense for investments in startups.
Equity
Instead, equity is the traditional method used to invest in startup companies. In an equity investment, the investor buys a specific number of shares in the company at a specified price.
$X, repaid not by the company but by some later acquirer
The company does not make payments to the investor. Instead, when at some future time the company is acquired, the buyer pays the investor a portion of the acquisition money in exchange for his shares. Occasionally, the company “goes public,” lists its shares on a public stock exchange, and then the investor can sell her shares just like the shares of any other public company. In this case, there is generally not one acquirer for the shares but many individuals and institutions.
If the company becomes profitable before any acquisition or public offering, then management (you) may choose to pay a dividend to shareholders. Unlike debt, such payments do not change the number of shares owned by the equity investor, i.e., the shareholder. Dividends are instead an additional financial benefit of being an owner of equity and simply add to the total return on investment.
Debt or Equity?
There are on rare occasions other forms of investments, but debt and equity are by far the most common forms of investment used to fund startups across all stages of growth.
The key difference between debt and equity is the risk/reward profile. Typically, debt is used where the risk is lower and the expected returns are between one and ten percent. Equity is used where the risk is higher, with expected returns between 3x and 10x (i.e., three to ten times more money returned than invested).
