So you have made the decision that you need to raise vital private capital funds for your business to either start or grow—and you have struggled with which is best for your business, debt or equity? These 2 ways to finance your business have 2 different regulatory requirements, 2 sets of differences (good or bad), and look 2 different ways to potential investors or debtors. Figuring out with your team what is the best funding approach is vital to future progress and future fundraising efforts so it’s important to make the right decision from the beginning.
NOTE: (1) This is NOT an exclusive list of advantages and disadvantages, (2) some disadvantages can be minimized by creative legal documents, and (3) you can always do a mix of debt and equity based on your funding strategy. This short post is meant to highlight a few thoughts for the budding entrepreneur.
- Liability on Balance Sheet. Debt, as you probably suspected, is just that: a liability for your company and on your balance sheet. If you are seeking a future round of financing, investors may be hesitant to invest in a company that has too much liability on its books.
- 1st Priority in Liquidation. In the case of a liquidation or merger, debt holders will be the FIRST to be paid before preferred stock holders and before common stock holders, which are usually the founders. So if you are a founder holding common stock, there are 2 layers of stakeholders that will be paid before you do.
- Less investor incentive. For investors that are contributing debt to your company, there may be less incentive to work as hard to grow the business than if the investor was a equity holder. Remember, debt holders are first in priority to receive funds in the case of a liquidation anyway so they have less incentive to grow the business.
- Cash drain on business. Since debt is essentially going to be a loan, it is going to be treated like every other loan. There are going to be monthly payments that the company has to make to the debt holder. For new companies that need cash to grow and re-invest in their business, this can be a severe drain of cash on a business that needs to use cash to fund or grow their business, especially new businesses.
- No equity in company. This is the most obvious advantage of issuing debt. When you are done paying the debt holder, you retain the same amount of equity in your business as when you first received funds from the investor. UNLESS you have a convertible note instrument that automatically converts the debt into stock at a preferred price upon the maturity date of the loan, equity is still given up but it is delayed.
- “Easier” to obtain. Easier is a subjective word but in theory, it’s easier for a company, especially a new company, to convince some investors to part ways with their money if they offer debt instead of equity for the reasons we stated above.
- Giving up some ownership. Obviously giving up some portion of your company is a hard and emotional decision but one that is required if you are seeking to raise private equity funds. It’s important to note that being a part of a successful business is always preferable to owning 100% of a failing business.
- More paperwork. Since there is a higher risk of the investors’ money with equity (since the investment is not guaranteed like debt) there is more paperwork that needs to be filed with government agencies and given to the investor when raising private equity funds. However note that “securities” is a broad term defined by the Securities & Exchange Commission (“S.E.C.”) so both debt and equity instruments will be regulated.
- More costly. For the reasons mentioned above, raising equity funds has more transaction costs. Additionally, there are numerous disclaimers and due diligence procedures that must be made based on the equity exemption the issuing company is raising funds under so your transaction costs, including attorneys fees, are higher. Naturally, since there is more risk that debt, the return on investment (ROI) required by investors will be higher in order for them to invest.
- You have to value your company. That’s the starting point for soliciting equity investors is to decide what your company is worth and what percentage of your company you are willing to part with at what price. There are legal documents that you can use to delay the valuation process to obtain a higher valuation in the future but they are not discussed here.
- No liability on balance sheets. While you still have to disclose other equity holders in your financial and corporate documents, equity doesn’t show up as a liability on your balance sheet, which is one of 4 financial documents you will need to prepare before raising capital.
- No cash drain. Equity holders only get paid when the company goes through an initial public offering (IPO) or merger. That means you can use cash coming into the business to make the business stronger and more profitable.
- It’s more fun. This may just be from my perspective but convincing an investor to buy into your business, really have skin in the game, and to reach your fundraising goal is much more exciting than debt.
- Investor knowledge and expertise. Most equity investors are interested in building a successful company and offer a wide variety of expertise and skills that debt holders (think banks) would not be willing to share. This is especially true if you use angel investor groups or venture capital (VC) funds.
Well there you have it! A brief synopsis on the pros and cons of debt versus equity. It’s not an easy to decision to make whether a company seeks debt, equity or a combination of the two. That’s why it is VITALLY important that you compose and surround yourself with a team of experts that are passionate about your business succeeding and can weigh the options with you from an accounting, legal and business practical side of things. Best of luck to you and happy capital raising!
NOTE: I will be discussing this subject in detail during our “Capital Chats” on Nov. 9th.
I am Dar’shun Kendrick, Private Securities Attorney and Owner of Kendrick Law Practice, helping businesses raise capital the LEGAL way. We work with “for profit” companies seeking to raise $250,000 or more through private securities (equity and/or debt) that have a line item budgeted for legal services. We do NOT find investors or introduce companies to investors; that is the job of “broker-dealers” and we are prohibited under federal securities law from doing so. I have 2 B.A.s from Oglethorpe University, a law degree from the University of Georgia and an M.B.A. from Kennesaw State University. NOTE: I will be discussing this subject in detail during our “Capital Chats” on Nov. 9th.
We are ONLY authorized to practice law in Georgia and therefore any legal advice in this blog only pertains to Georgia based businesses. Please visit us online to sign up for a time to discuss services or for our famous 10 point Business Legal Consultation for 1 hour.
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