Debt vs. Equity - Inside the Mind of Both Types of Investors

As we covered in our article ‘What is Debt’, leverage of capital is a key differentiating factor and tool for success for startups, but raising equity capital is a very different activity compared to raising credit capital. Founders who have a deep understanding of how to navigate equity capital raising should be aware of the different ways equity investors and credit investors (aka. ‘Lender’) think. Being able to understand these differences will help speed up the credit capital raising process and ensure the best outcomes. 

What are the investors objectives?

All investors - equity or credit or other - all have some common incentives. They are generally all trying to deploy a set amount of capital in a specific amount of time within an investing thesis or mandate. The individual who is making the investment will be incentivized (usually through monetary compensation) to work within these parameters to try to generate the best outcomes possible while avoiding unacceptable risks.

5 key parameters both equity and credit investors think about - but think about differently - are:

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Both types of investors can conduct extensive diligence but commonly credit capital investors will conduct more intensive diligence, and at a minimum they will ask different questions. Equity investors are principally interested in determining upside and understanding what factors could kill the company (regulatory, PMF, hiring, competitive environment). Credit investors are more concerned about stability of growth vs. underwriting plans and operational or regulatory issues that could arise. Credit investors will also generally have the ability to structure their documents to box in some of these risks. Equity investors on the other hand usually can’t legally box in a company, they affect change more through providing strategic advice and introductions. 

A helpful example we often use when discussing equity and credit is the parallel to purchasing a home - a task many have done themselves or are at least familiar with.

• Very few individuals purchase a home using 100% cash. In fact in the US, less than 30% of all home purchases are in cash. The remaining ~70% make their purchases using leverage through a specific financial product (more commonly referred to as a mortgage). 
• The mortgage gives the customer the ability to purchase a home that they don’t have enough cash to pay for entirely. This invention has allowed millions of individuals here in the US to become homeowners. The idea of using credit capital really underpins all of modern financing and banking. Banks were established principally to allow for the exchange of capital from those who have it and don’t need it, to those who don’t have it and need it. 
• For example: 

• Alex wants to purchase a $500,000 home. Alex has $100,000 in cash and has been approved for a $400,000 mortgage from a bank. 
• Alex combines the $100,000 and the $400,000 and purchases the home. He now owns a $500,000 home. However, as a condition for the mortgage from the bank, Alex must allow the bank to place a lien on the house. This lien gives the bank the right to sell the house if Alex stops making regular payments on the mortgage or fails to comply with any other requirement attached to the mortgage. 
• Alex has used leverage to purchase a home! 

Our Advice for Entrepreneur

We believe that addressing the topics that a credit investor focuses on as early as possible in a startups lifecycle will help create a more resilient business through and through. We are realistic in that we understand there are often a million projects all competing for resources, but we’ve seen plenty of companies that thrive because they chose to prioritize operational, regulatory and infrastructure as early as possible.

Debt should not be considered a replacement for equity. In reality, when evaluating early-stage firms, venture financiers frequently utilize equity as their main form of validation. As a result, many entrepreneurs raise debt following an equity round. 

If a considerable amount of additional equity capital is needed to fund the company, accepting heavy debt at the seed stage is usually not the best course of action. Typically, institutional VC investors don't want to see a significant amount of their new equity going toward paying off previous debt.