Raising Money for your Company
Let’s say you have started a new company and now you need to raise money from investors in order to bring some outside capital or investment into your company. Do you set up an equity financing and sell shares to equity investors? Or do you take in new investment as debt that must be repaid?
When getting ready to raise money, many entrepreneurs and small business owners are not sure how to structure the proposed financing that they need and often ask questions similar to the following:
- “Should I raise money with debt by issuing promissory notes to investors in exchange for their investments into my company (debt financing)?” or
- “Should I raise money with equity by selling and issuing shares of my company’s stock to investors in exchange for their investments into my company (equity financing)?”
Often the question is very simple: “I need to raise money! What do I do next?”
To help you answer these questions and to guide your company’s fundraising efforts, below are six key issues that highlight some important differences between a debt financing and an equity financing and what the consequences to your company will be:
1. A debt financing does not change your company’s ownership structure
When your company receives debt financing, your company’s ownership structure does not change, because the investors receive a promise from the company to repay the debt (a promissory note). No new stock is issued to the debt investors and you and the other existing stockholders of your company will continue to have the same relative equity ownership positions in your company as before the debt financing. In other words, the debt financing will not cause any stock ownership dilution to you and the other existing stockholders. Note, however, that a convertible note financing is a hybrid debt/equity financing structure, because it starts out as a debt financing and later may become an equity financing if certain conditions are satisfied and the outstanding debt converts into shares of stock.
2. An equity financing does not require repayment to the investors
After an investor acquires stock of your company through an equity financing, your company will not be required to return or pay back the investor’s money (unless of course the investor negotiates for and receives a redemption or similar repayment right). With a debt financing, the principal and interest on the loan eventually will become due and payable at some maturity date in the future. Your company then could face cash flow issues when it is required to repay all of the outstanding debt. Your company also could have additional complications and challenges if the debt financing is secured by your company’s assets (e.g., intellectual property), such that the debt investors can look to your company’s assets as security for the repayment of the debt. Equity investors are owners of your company and will be with your company for the long term.
3. A debt financing can help you avoid difficult valuation negotiations, especially if your company is an early-stage company
All equity financings involve a determination of the value of your company, because your company is receiving some amount of investment for a related ownership percentage of your company. For example, if an investor is willing to invest $100,000 for a 10% equity ownership stake in your company, then the corresponding pre-money valuation of your company is $900,000 based on these investment terms.
When negotiating a financing deal with your investors, the valuation question will be one of the key terms that you will need to negotiate and finalize. As an owner of the company, it is in your best interests to negotiate a higher valuation for your company (resulting in less ownership dilution to you), whereas the investors will argue for a lower valuation for your company (resulting in a larger ownership stake for the investors after their investment). This valuation question often times is more art than science, especially during the early stages of your company. For example, your company may not have a long financial history and there may not be relevant comparison companies to help determine the valuation of your company.
In some cases, it may be in your company’s best interests to side step the valuation question and structure the investment as a debt financing (including a convertible note financing). In that way, your company will receive the needed financing, and you will not become deadlocked on valuation and ownership percentages as you try to bring money into your company. Of course, if you are able to negotiate a valuation that makes sense for your company, then an equity financing at the early stage could be the preferred alternative for both you and the investors.
4. Debt investors are paid back before equity investors
Debt investors are at the top of the Liquidation Waterfall, meaning that they will get paid before any of the equity investors or stockholders of the company. For example, upon a Liquidity Event, the debt investors and other creditors of the company would be paid first, before any payments or distributions go to the equity investors and stockholders.
5. Equity investors do not go away
Once investors become stockholders of your company, they will continue to be owners of your company for the long haul. They have invested in your company and are hoping to see a sizable return for the risk that they have undertaken as owners. Also, depending on the size of their ownership stakes and certain rights, privileges and preferences that they may negotiate as part of the equity financing, the equity investors may have the ability to approve important company matters (such as future stock offerings, the sale of the company, etc.), receive detailed company information and receive payout on their investments before the other, more junior stockholders.
To the extent possible, it is important to select your investors wisely because of this long-term relationship. Ideally, “smart money” investors may help open doors and make introductions that can be helpful to your business in the future. Conversely, if you get in bed with the wrong equity investors, they might believe that they have a larger managerial role in the business than what they really should have and they might become a distraction, drain of time and resources or worse.
Savvy debt investors also may tie up the company with various financial and operational covenants, as well as approval requirements and other restrictions.
6. Debt secured by all of your company’s assets can be dangerous
A debt financing can catch your company by surprise if you’re not careful. For example, if the outstanding debt is secured by all of the assets of your company and your company defaults on its repayment of the debt, then the debt holders may have the ability to enforce payment by taking possession of and selling your company’s assets. In order to avoid this “acquisition” of your company by the creditors, it is very important that you negotiate that your company’s assets will not secure the debt. You may be successful negotiating unsecured debt with friends and family debt investors, but banks and other more sophisticated investors likely will require a security interest in your company’s assets as well as other protections. Also, beware of the personal guaranty and how it will affect you personally if you have to stand behind the payment of the outstanding debt.
Have you raised debt or equity financing from investors? If so, how did the process go and has the financing choice served your company well? Please share a comment below and let us know how the financing has helped your company, so that other entrepreneurs and small business owners can learn from your experiences.