Equity vs Debt Funding for Startups Explained

When it comes to funding a startup, most founders immediately think of equity investments. Debt financing, by comparison, remains a less common route, often misunderstood or overlooked entirely. However, for the right business, it can be a smart strategic move.

Debt or Equity? Choosing the Right Startup Funding

The critical difference between debt and equity funding is in ownership and repayment. With debt, the business receives capital that must be eventually repaid, usually with interest. The lender won’t gain any ownership stake in the company and is not entitled to future profits or an exit upside.

As Adrian Dommissee, Founder of Dommissee Attorneys, puts it: “Lenders aren’t owners, they’re not contributors of permanent capital.”

Founders who pursue debt funding are comfortable with the idea that revenue exits the business while they pay off the debt. For them, the focus is on using the capital to fuel growth, rather than preparing the business for a future equity exit.

By contrast, equity funding means the funder is an investor or owner of the company. They give money to the business without wanting to be paid back but rather want the value of their shares to be maximised over time.

“The key negotiation in equity funding is dilution,” says Dommisse. “How many shares will the investor get for their capital? That’s why understanding your pre-money valuation is critical.”

He explains that valuation often hinges on forward-looking metrics: “Look at your future revenue discounted to today’s value. If that’s not feasible—perhaps because there’s no revenue yet—then consider your net asset value, based on your balance sheet.”

However, for early-stage startups, particularly those pre-revenue, traditional valuation models often don’t apply. In these cases, venture capitalists (VCs) tend to back the founders and their team more than the product itself.

“You can bring as many graphs and projections as you want. It's just speculation. Investors are assessing whether your team is capable of executing the vision. If you're looking for permanent capital and long-term growth, equity is typically the way to go.”

What is a SAFE Agreement in Startup Funding?

One form of early-stage financing is SAFE contracts. A Simple Agreement for Future Equity (SAFE), is a contract between an investor and a startup where the investor provides capital upfront in exchange for the potential to receive equity in the future.

The agreement is beneficial to startups that do not yet have a comprehensive valuation of the business. It postpones the valuation conversation while still giving investors the potential for ownership later on.

“A SAFE should be five, six pages. It’s pretty much standardised. Hardly any due diligence, minimal legal involvement. Founders to adjust a few key fields such as the investment amount, discount, and valuation cap.” explains Dommissee.

Why Over-Negotiating SAFEs Can Hurt Your Startup

Many founders fall into the trap of over-negotiating these simple agreements through side letters. Side letters are additional, separate agreements between the startup and an investor that outline specific terms and conditions not covered in the main SAFE document. These can be anything from governance, share dilution and liquidation terms.

While side letters are sometimes seen as necessary to clarify terms, Dommissee warned that these ‘add-ons’ risk turning a quick SAFE deal into a full legal negotiation. This can result in founders spending too much time and accumulating legal feels on what was meant to be a straightforward funding instrument.

“You end up negotiating effectively Series A-type terms at your SAFE level, which extends the process terribly. If your SAFE takes longer than three weeks to negotiate, then you've got a problem,” Dommissee warns.

How Valuation Caps Work in SAFE Agreements

Dommissee explains that one of the most important – and misunderstood – elements of a SAFE is the valuation cap. A valuation cap in a startup is a pre-determined maximum valuation at which an investor's convertible security (like a SAFE or convertible note) will convert into equity.

Adrian illustrated the concept with a practical example: “Let’s say the cap is R100 million. If I invest R10 million, I expect to own at least 10% of the company. That’s how I justify coming in so early.”

This can go wrong if founders miscalculate or stack SAFEs without adjusting their post-money cap. Basically, if you raise multiple rounds at the same capped valuation but fail to account for the growing total investment, your own shareholding can be dramatically diluted.

“Post-money caps in your SAFEs can radically dilute founders because there’s only one source of dilution,” he said. “Founders need to approach caps not as implied valuations, but as an expression of the equity they’re willing to give away in return for capital.”

Pre-Money vs Post-Money Valuation Explained

A critical concept that founders need to grasp is pre- and post- money valuation. Pre-money valuation is the value of the company before investment, while post-money valuation is the value of the company after investment is made.

Dommissee provided a simplified breakdown of the concepts, he said, “If you think your company is worth about R90 million today, and an investor gives you R10 million, then your post-money valuation is R100 million. That means you’ve effectively sold 10% of your company.

He explains that if you raise another R10 million on the same post-money cap, the maths no longer holds: You’ve collected R20 million in total. Your post-money valuation should now be R110 million. But if you keep it at R100 million, then your dilution just doubled.

He emphasised that startups must understand that post-money caps are cumulative, “any SAFE you issue adds to your total dilutions, and unless you adjust your cap upwards, you will give away more equity than what you planned.”

Download Free South African SAFE Agreement Templates

The good news for local founders is that there are localised SAFE templates available for download. Dommissee Attorneys has created a locally tailored version, which he encourages startups to use, especially in the early funding stages.

“We created the version for South African entrepreneurs and founders,” says Dommissee. “You can print it out, change the cap, change the investment amount, and it's ready to go.”

Choosing between debt and equity needs to be a strategic decision, not just a financial one. Equity can provide long-term growth capital, but it comes with dilution and shared control. Debt financing offers immediate funds but requires repayment regardless of business success.

Understanding concepts like SAFEs can help founders navigate early-stage funding with confidence and clarity. Having the right legal and financial guidance is key to making informed decisions that support sustainable growth.