Startup Investment Types: Equity vs Debt
This is one of the most critical decisions you will make as a startup. The conditions for repayment and ownership are primarily determined by the type of investment you secure. There are two main paths: Equity and Debt. Most early-stage startups use equity-based instruments.
1. Equity Investment (Giving Up Ownership)
This is the most common route. You exchange a percentage of ownership in your company for capital.
Key Instrument: SAFE (Simple Agreement for Future Equity)
- What it is: A SAFE is not a loan; it’s an agreement giving investors the right to receive equity during a future priced round (e.g., Series A) under conditions set today.
- Repayment Condition: No repayment. The investor’s money converts into shares. They get paid only if the company succeeds (acquisition or IPO).
- Ownership Condition: The investor receives ownership later, determined by a valuation cap and/or discount.
- Valuation Cap: The max effective valuation at conversion (e.g., $5M cap means shares priced as if company is worth $5M, even if Series A values it at $15M).
- Discount: Typically 10-20% off the next round’s share price.
Key Instrument: Priced Round (Seed or Series A)
- What it is: Sell shares at a specific price, officially setting valuation.
- Repayment Condition: No repayment. Investor owns shares and profits at a liquidity event (acquisition or IPO).
- Ownership Condition: Immediate ownership.
- Example:
Raise $500,000 at $4.5M pre-money valuation.
Post-money valuation = $4.5M + $0.5M = $5M.
Investor ownership = $0.5M / $5M = 10%.
Founders and prior owners diluted to 90%.
2. Debt Investment (Obligation to Repay)
This is a loan that must be repaid with interest, sometimes convertible to equity.
Key Instrument: Convertible Note
- What it is: Short-term loan that converts to equity during future funding rounds.
- Repayment Condition:
- Conversion: usually converts to equity upon a qualified financing (e.g., >$500K raised).
- Repayment at maturity: if no funding round by maturity (~18-24 months), repay principal plus accrued interest in cash—which can be risky if the startup lacks cash flow.
- Ownership Condition: At conversion, ownership determined by valuation cap and/or discount like a SAFE.
Key Instrument: Bank Loan / Traditional Debt
- What it is: Traditional loan from bank or financial institution.
- Repayment Condition: Strict monthly repayment of principal plus interest, starting immediately regardless of business performance.
- Ownership Condition: No ownership given up. Lenders are creditors.
Summary Table: Key Differences
| Instrument | Repayment Condition | Ownership Condition | Best For |
|---|---|---|---|
| SAFE | No repayment. Converts to equity. | Issued later based on valuation cap/discount. | Very early-stage startups (pre-revenue, pre-product). |
| Priced Round | No repayment. Investor owns shares. | Issued immediately; dilutes founders. | Startups with traction ready to set a valuation. |
| Convertible Note | Usually converts to equity; may require cash repayment if note matures without funding round. | Issued later based on cap/discount. | Early-stage startups (common before SAFEs). |
| Bank Loan | Strict monthly cash repayment plus interest. | No ownership given up. | Cash-flow-positive businesses with collateral. |
Crucial Advice for Your Startup
- SAFEs are the standard: Popularized by Y Combinator, SAFEs avoid maturity dates and repayment risk.
- Understand dilution: Selling equity reduces your ownership percentage; model your cap table carefully.
- Valuation cap is key: Lower cap means more equity for investors, more dilution for founders.
- Get professional help: Hire a startup lawyer to explain terms, ensure proper paperwork, and protect interests.
In short: avoid debt if you have no revenue. Use equity instruments like SAFEs to exchange future shares for cash today, accepting dilution as part of the funding process.