Startup: Loan or Investment?

Wordle Loan or InvestmentYou have a great idea for a company.

You’ve validated that the market wants the product and is large enough. You’ve determined that their pain is significant and you’ve found the right messaging that hits their pain point.

Your product is unique and early tests indicate that customers want your product much more than they want competing products.

You’ve found ways to protect your intellectual property so competitors cannot copy you.

You’ve created financial models that show you can be profitable by the end of the second year, and cash flow positive by the third year.

You have just one problem left: You need $350,000 to get the company started. The big question is: should you try to obtain a loan? Or should you try to obtain an investment?

For experienced entrepreneurs, it is an easy answer based on experience. For the new entrepreneur, the choice can be gut-wrenching. Let’s explore what the choices of loan or investment and their pros and cons.

What’s an Investment?

An investment occurs when investors (usually angels or venture capitalists, but it could also be friends or family members) provide the company with $350,000 and you sell them a part of your company.

For example, if you and the investors were to agree that your company was worth $1,050,000, then you could sell one third of the company to them for $350,000. If you and your co-founders owned, for example, 1,000,000 founders’ shares and the company needed $350,000, the company would need to sell 500,000 shares to the investors and they would then own 500,000/1,500,000, or 1/3, of the company.

Notice that it would not be sufficient for you and your co-founders to sell them a third of your 1,000,000 founders’ shares. If you did that, the investors would need to pay you $350,000, and the company would get nothing!

Some variations exist:

  • As managers of the company, you have complete control over the success of your company. The investors have almost no control; yet all their investment is at risk.

    For that reason, and to make the playing field just a wee bit more level, most investors demand 
    preferred shares. Many possible preferences could be requested by investors, but the most common is called a liquidation preference, which means that investors get back their original investment (or a multiple of it) prior to a general distribution of the proceeds of the sale of the company.

What’s a Loan?

A loan occurs when a creditor (usually a bank, but it could also be a friend or family member) provides you with $350,000 and you promise to pay it back in even installments over a period of time, with interest.

For example, if you were to obtain a 7-year, $350,000 loan from a local commercial bank with an 8% interest rate, you would need to pay $5,500 each month for 7 years to repay the loan.

In general, lenders expect personal guarantees; if your company cannot make payments on the loan, you will be personally responsible to make the payments, and that means you could lose your house or your car.

Whether or not you are willing to put these items up for collateral is a good indication to the lender as to whether or not you believe in your own company. If you wouldn’t risk your house, why would you expect them to take the risk? At the end of the seven years, you would be free of any obligation to the bank.

Some variations exist:

  • A balloon loan lowers the monthly payments during the term of the loan, but then includes a much larger one-time payment at the end of the term. In the above example, monthly payments could be $4,000/month, and then a balloon payment of $166,000 would be due at the end of seven years.
  • An interest-only loan allows the company to pay just the interest on the loan each month, but then must repay the entire loan at the end of the term. In the above example, monthly payments could be $2,333/month, and then the company would pay the bank $350,000 at the end of seven years.
  • A convertible loan allows the creditor to convert the outstanding balance of the loan into equity. In the above example, interest would accrue but not be paid, so if the loan converted to equity at the end of one year, the creditor would become a shareholder with $379,000 worth of stock.

Advantages of getting an investment

The advantages of obtaining investments rather than loans include:

  • No monthly payments required.
  • Investors can generally provide much larger sums than lenders can.
  • Owning a smaller piece of a huge pie rather than a larger piece of a tiny pie.
  • You might not be able to find a lender interested in your company.
  • Generally no collateral is required.

Advantages of getting a loan

The advantages of obtaining loans rather than investments include:

  • No loss of “control”.
  • You might not be able to find an investor interested in your deal.
  • You might be in an industry that produces returns insufficiently high to attract investors.
  • You might be in an industry without any possibility for liquidity.
  • You and your co-founders may want to manage a life-style company and never sell the company (no liquidity event -> no investor interest).
  • Interest rates are much lower than investors’ expected internal rates of return (IRR).

Summary

If you need cash for your new company, many options exist, but don’t expect anybody to take the risk without you taking at least an equal risk.

If that risk is a loan, you will need to risk your personal assets. If it is an investment, you will have to offer preferences, which puts your personal piece of the pie at risk. However, as long as do well, there will be plenty of returns for everybody. Neither lenders nor investors want more than they deserve; what they want is shared risk.

Al Davis is a serial entrepreneur currently in his fifth startup.  He is also an angel investor and the author of six books.