Equity, debt or a hybrid instrument — what should you offer investors?

Equity, debt or a hybrid instrument — what should you offer investors?

Equity, debt or a hybrid instrument — what should you offer investors?

It is common knowledge that the primary things which investors evaluate are the product and the team. Even though these criteria are the most important, it's still possible to lose financing if the offering is poorly structured, i.e. if the investor rights aren't protected, or a return on investment ends up low, hard to get or delayed in time. On the other hand, giving your investors an unfair edge by giving too favorable terms is also not a winning strategy.

Economics of financing your company: debt or equity

The first criterion mattering for investors is the type of financing your company provides, which can be either debt or equity. Debt financing has a more discernible pattern: it suggests borrowing money from investors while paying interest during a certain period of time and eventually giving the entire sum back. In this case, the return investors acquire is determined by two parameters: how fast this debt can be repaid (this is called duration of the debt) and the interest rate offered to investors. Both of them depend on your return on capital. Return on capital corresponds to how much income can be generated for a company per each dollar of its working capital. For example, if the return on capital rate reaches 10%, it means that with $10 million of capital, the company generates $1 million in income. In this case, a company can offer up to a 10% interest rate to investors.

The precise interest rate is determined based on market practices: it depends on how risky it is, its duration, and so on. Usually, the riskier the offering, the higher the interest rate.

Equity financing means selling the shares of your company to investors. As a result of this process, they become the company co-owners and participate in share capital. When searching for equity financing, you need to determine which particular percentage you should give to investors. There are two most common ways to do it.

Firstly, by evaluating the company's assets: let's say it has $10 million worth of assets and attracts $10 million financings. As a result, this company is now worth $20 million. As the second $10 million was brought here by investors, they should receive 50% of shares.

Alternatively, you can come up with a valuation for a company by adding all its future income. If, for example, a sum of all the future cash flows equals $20 million while investors put in $10 million, it all comes down to 50% shares as well. Notice that when evaluating the future cash flows, you need to discount them, considering that money today is more valuable than money in the future. You can learn more about it in our video “How investors assess your corporate finance. Private placement, equity crowdfunding, IPO, STO”.

The returns equity investors get depend on the earnings per share parameter divided by the price per share. The offering can become more lucrative by reducing the cost per share for such investors. On the contrary, raising a price per share won't be a bad idea if your business generates more than significant investor interest.

The benefit of debt financing is that it's more predictable and safe for investors. The advantage of equity financing is that business doesn't have to pay back the body of the debt. Additionally, investors enjoy dividend distributions and become full-fledged co-owners of the asset, which allows them to profit from capital appreciation, namely the fact that the company by itself is becoming more valuable. Therefore, equity financing is riskier but also more profitable for investors.

Challenges of equity financing for the newborn company

Equity financing is much more commonly used for already-established businesses. In such a case, there are assets on the balance sheet that can be evaluated and the historical cash flows, which can be projected into the future. If you'd like to conduct equity financing for the newborn company, there are two challenges.

The number one problem is that future cash flows are unclear and unpredictable since this company didn't exist before and its market isn't tested. Therefore, it's harder to persuade investors to believe in your valuation, and they are likely to demand a significant discount to reduce their risks.

Problem number two is that if the investors seed 100% of the company's capital, they respectively should hold 100% of its stock. If they don't, they get a net loss. For instance, if the company had a $10 million investment while investors received only 50% of its shares, they are left with assets worth only $5 million. In comparison, another $5 million is now owned by founders. They would be able to recover the losses and get profits only if the company grows incredibly fast.

Due to these reasons, traditionally, new companies are more accustomed to fundraising by taking a loan from a bank or by issuing bonds. Still, one of the main reasons companies head towards tokenization is the desire to engage in more creative equity financing forms and offer investors the benefits of fractional ownership.

Variants of equity financing for new projects

You need to offer investors more complex schemes than a simple direct investment in shares to finance new projects through equity.

Convertible debt

The first option is that you can offer Convertible debt. Instead of evaluating the company at the dawn of its operation, investors receive fixed-rate bonds. After a while, they will be able to either redeem the bonds and receive payment or convert them into common stock. The benefit of this method is that in 3 or 5 years, it will be possible to value the company with higher precision, so investors will get shares on a valuation based on reality rather than unclear anticipations about the future. For example, if the initial debt was $10 million and in 5 years the company is valued at $20 million, investors will acquire 50% of shares.

Convertible preferred shares

The second option, which is slightly less favorable for investors, is Convertible preferred shares. Just like in the case of debt, investors acquire a guaranteed fixed income. However, they can't get a body of the investment back: only converting preferred shares into common ones is possible.

Convertible debt is an option slightly more attractive to investors, as it provides some flexibility for them: they can take their money back if they don't like the company's performance before actually converting it into shares. Preferred stock financing doesn't allow this option. Still, if the company is reputable enough and investors are likely to trust its execution capabilities, it's also feasible.

Convertible debt and convertible shares are prevalent in venture capital financing. Read our article "Conventional clauses in venture agreements and why you should choose tokenization instead" to learn about the economics of venture capital and how tokenization improves startup financing.

Management incentives

The third option is to give 100% equity to investors straight away, leaving management with special bonuses and incentives based on their performance. This option is prevalent among investment funds, where the usual annual management compensation constitutes 2% of capital under management and a 20% success fee. This model can also be used not only for funds but for specific businesses as well. It solves the problem of investors giving away their money to founders if they don't receive 100% of shares for putting 100% of cash in.

Revenue share

The fourth option is Revenue share. This one is a hybrid of equity and debt financing: investors get an income based on the company's performance rather than a fixed one, similarly to dividends. In the meantime, the investors do not become shareholders and aren't entitled to any equity but only to cash payouts. Sometimes, the revenue share may include the right to the redemption of tokens. Redemption means a possibility to burn your tokens and get the invested money back. If there is a redemption, revenue share will look more like debt financing; if there isn't, it's more similar to equity financing. Revenue share model without redemption makes sense only if the investors' return from revenue payouts is really high: investing a dollar in order only to get 5 cents a year isn't attractive if you can't take this dollar back and, therefore, need to wait 20 years for your investment to pay off.

Creating liquidity for your tokens

If the business adopts the equity financing strategy or the debt with a long duration (i.e. more than five years), creating liquidity for its tokens should be a high priority. In equity financing, its return is not limited to dividends but also includes the token value growth due to the company's capital appreciation. Still, to benefit from capital appreciation, the token has to be sold. In debt financing, many investors are likely to want their money back long before its 20-year maturity, which is also possible only if the token is traded.

Lack of liquidity is one of the reasons why previously new projects financing used to engage in equity financing relatively rarely. However, tokenization enables the trading of tokenized securities, making new projects' equity financing more feasible. You can learn more about how tokenization allows secondary trading in our article “How does DeFi unleash the potential of tokenized securities?”.

Stobox DS Swap is a decentralized solution to unlock secondary trading for security tokens. Investors can sell their security tokens or buy more using an automated liquidity pool. Learn more

Long story short, there's plenty of options to structure your financing round, the best of which depends on the specifics of your business, including your return on capital, management experience, financial structure, as well as many other factors. The Stobox team will be glad to help with your fundraising campaign: sign up for the 30-min consultation to find out more.