Written by Alex Liu
This article was originally published on UpCounsel.
When considering small business financing, it’s important to understand all your available options. Otherwise, investors can easily take advantage of you and offer unfair terms. So before raising any money, learn if equity, debt or convertible debt financing makes the most sense for you to grow your business.
Equity
Raising capital through equity is popular, if not the most popular choice, for entrepreneurs to pursue. Investors buy stock in your company, giving them a financial stake in the future success of your business.
How It Works
- You set a specific dollar amount for what your company is worth.
- Based on that valuation, investors agree to give you money in exchange for a certain percentage of your company.
- Investors receive compensation based on the percent of stock they own once you sell the company or go public.
Pros
- All your cash can go toward your business rather than loan repayments.
- Investors take on some risk and don’t have to be paid back until you’re doing well.
- Investors often have valuable business experience.
- Since investors have a financial stake in the success of your business, they are motivated to offer sound guidance and valuable business connections.
Cons
- Equity financing has the highest legal bills and takes the longest time to close, making it the most complex small business financing structure, says Forbes contributor and growth consultant George Deeb.
- Selling shares of your company makes it very difficult to get them back.
- You will most likely lose control of part of your board to your investors.
Debt
Debt-based fundraising is the form of small business financing most small businesses end up choosing, says Fundable. It’s also the easiest to understand. Money is loaned to you with the agreement you’ll repay it over time with an established interest rate.
How It Works
- You borrow money with an agreement to pay it back with interest within a specific time frame.
- You will also have to offer your lender some form of collateral, which are liquid assets you will give up if you cannot make your loan payments.
Pros
- You will raise capital much quicker than with equity small business financing. This is especially true of smaller cash amounts.
- You can keep 100 percent of your company, along with 100 percent of its profits.
- Interest payments are tax-deductible.
Cons
- You must be completely confident you can make your loan payments in cash each month. If you don’t, lenders can make you sell your business in order to get their money back.
- Interest payments can become one of your largest business expenses.
- Commercial lenders will demand small business owners to personally guarantee the loan and offer personal assets as collateral, even if your company is structured as a corporation or limited liability company, according to Forbes.
Convertible Debt
A convertible debt small business financing structure is a mix of debt and equity financing. The money raised is considered a loan, but at some future date, the loan can convert to equity if the lenders so choose.
How It Works
- You will negotiate an interest rate to pay back the loan. This will also be the interest rate for those lenders who decide not to convert any debt into stock.
- The details concerning how lenders can convert the debt into equity are negotiated at the time of the loan. For the most part, that means agreeing to give lenders a discount or warrant on an upcoming round of equity fundraising.
- You will also set the valuation cap, or maximum company valuation, at which lenders can convert debt into equity. If investors decide not trade in their loan for shares at this predetermined valuation level, they can no longer do so at a future date.
Pros
- Transaction costs are low and the process moves quickly.
- If you don’t want to set a company valuation, which involves a lot of uncertainty and risks for new startups, a convertible debt structure for small business financing makes a lot sense, says Covestor CEO Asheesh Advani.
- Using convertible debt protects investors from dilution in future financing rounds.
Cons
- Investors are uneasy about giving money without knowing the exact share of a company they will own, and you might have to offer steep discounts on equity in order to get them to agree to the terms.
- You may be forced to set a valuation before you are ready in order to avoid unaffordable loan repayment expenses.
In the end, it’s best you make your final choice, best on which specific option, works best for you, not just now, but in the immediate future as well.