Everyone knows the saying, “to make money you need to spend money”. Well, this statement strikes a chord with all business owners, as you need to fund your business operations to keep the wheels of your business moving forward, whether it may be on infrastructure, advancing the growth strategy of your business, employing staff, purchasing assets, marketing and meeting the specific needs of the company.
Having capital, or access thereto, is essential to ensure the survival of your company. With that said, we consider, two commonly used external capital financing agreements, namely:
- Equity Financing Agreement; and
- Debt Financing Agreement
Equity financing occurs when the company shareholder sells a certain percentage of its shares (equity/ownership) to an investor in exchange for capital. This type of arrangement is generally formalized in a sale of shares agreement.
The upside of entering into an agreement of this nature is that there is no obligation to pay back the funds or interest on the amount that you received from the investor. After the share transfer is completed, you are in bed with the investor, which means you will have to share in the profits and consult with the investor before making decisions regarding the company. As co-shareholders in the business, you will have a joint interest to ensure that it is successful – it is the only way your new co-shareholder will realize a return on his/her investment.
Before deciding to proceed with an equity financing arrangement, please ensure that you select the right investor who will share your goals and vision for the business, and more importantly, add value!
This arrangement occurs when you borrow money from an investor based on the understanding that the money advanced (or loan) will be paid back at a future date with interest.
This type of arrangement is generally formalized through a loan agreement. There are more sophisticated agreements that provide for this type of arrangement, but it incorporates the option to convert the debt into equity at the borrower’s option. These types of contracts are convertible notes or simple agreement for future equity (SAFE). For purposes of this section, we focus on the loan agreement.
The upside of entering into a debt financing arrangement allows you to stay in full control of your business without giving away any equity. The money received can be used to catapult the growth of your business to its next major milestone. You must remember that for whatever purpose you use the funds, it must be paid back to the borrower, with interest, regardless of the business revenue generated. This can be risky, especially if your business is in the infancy stages. Some investors may require you to sign surety or provide a guarantee that the money loan will be paid back. With that in mind, always ensure that you utilize the funds wisely and strategically to create value in your business.
WHICH OPTION IS BEST?
To decide which option will be best, it will significantly depend on the needs of your business. If it is a short-term need, it is best to consider debt financing. If it is a long-term need, equity financing may be suited. Either way, in both options, there are advantages and disadvantages.
In short, if you have an investor that shares your values, goals and vision for the business, and can add value, then best to consider equity financing. If the investor cannot add value and is merely looking to return on their investment, debt financing would be more appropriate.
If you find yourself in a situation where you have either of these financing options available to you and require legal guidance or advice, please do not hesitate to contact BBP Law Attorneys.