Pursuing funding for a business is an exciting process, but can often be intimidating to even the most experienced founders. Although most businesses are initially funded by the personal assets of their founders, most businesses will require some form of outside funding in order to thrive. While there are pros and cons to outside funding, being adequately informed about the different types of financing is crucial, as it will ultimately help a business make the most informed choice on what is right for its specific enterprise.
Ultimately, while there are multiple mechanisms businesses utilize in order to achieve their funding goals, most of them can be condensed into two primary categories: Debt Financing and Equity Financing. Debt financing involves injecting capital into the business by obtaining loans, lines of credit or convertible debt, while equity financing involves selling some form of ownership of the business in exchange for capital. Each of these forms of funding are explained below in further detail.
One of the most established ways of funding a business is by taking on debt in some form or fashion. For a business, taking on debt does not necessarily imply the same negative connotations it may receive in the personal finance space. In fact, most financial experts agree that a healthy amount of debt in a business can help optimize the balance sheet, cash flow, and leverage. With that said, here are some of the different forms of debt business may choose to take on:
Unsecured Debt – is debt that is not backed by an underlying asset used to secure the obligations of payment or performance. Below are some of the most common ways businesses take on unsecured debt:
- Friends and Family – Friends and family tend to be some of the earliest adopters and advocates of a founder’s business. While the initial benefits are typically advantageous, founders should be considerate that taking on unsecured debt from friends and family may be one of the easiest ways to turn trusted relationships sour in the event things do not work out as planned.
- Private & Government Grants – Some (not all) grants offer non-dilutive loans or grants to founders or their businesses. This form of unsecured debt tends to be highly competitive, but the benefits could provide a sizeable chunk of non-dilutive cash in order to get the business running.
- Angel Investors / Loan Providers – On certain occasions, a select number of angel investors or third-party loan providers may provide unsecured debt or “bridge loans”; however, these investors tend to attach additional obligations, such as agreements by the business to provide future rights or services. Furthermore, these types of arrangements tend to have a shorter maturity date (i.e. payment is due within weeks or months), and may also include interest rates higher than the prevailing market rate.
- More Sophisticated Arrangements – For larger organizations (i.e. middle-market and multinational companies), unsecured debt arrangements can become much more complex. These businesses may restructure and sell off outstanding notes or debt of the business. They may also conduct short term overnight financing arrangements to manage cash flow or satisfy regulatory requirements.
Secured Debt – is debt that is backed by an underlying asset used to secure the obligations of payment or performance. Below are some of the most common ways businesses take on secured debt:
- Traditional Bank Loans – One of the most often utilized forms of secured debt, local, regional, and national banks continue to provide the primary source of early business financing. It is important for founders to understand that banks primarily generate money off interest rates and fees originated from the loans and are typically tailored for businesses with a more conservative risk profile. If a business is considered “high risk” (i.e. technology, software, niche products, etc.) or is not well established, the terms of the loan (if any) may be less favorable than more traditional businesses. In addition, banks may require personal guarantees from the founder(s) in order secure the debt obligations of the business.
- Secured Lending – Most businesses will utilize some form of alternative secured lending, which can follow traditional arrangements (e.g. automotive loans or mortgages), as well as leverage extremely sophisticated arrangements (e.g. stock loans). Given the variation of secured lending arrangements, founders should pay close attention to what assets are securing the loan and the relative value of the pledged assets compared to the loan amount(s).
- Lines of Credit – Many institutions and financial services companies will offer lines of credit for businesses to draw against a set maximum amount. These arrangements tend to provide greater flexibility for the business to allocate amounts to specific needs as they arise from time to time. A business should maintain caution, however, to ensure that the line of credit is utilized to efficiently run the business and does not become a financial burden.
- Private Agreements – There is a select number of private debt issuers that prefer to offer pure debt arrangements to businesses rather than take equity or some type of convertible equity arrangement. Entering into a secured debt obligation with a private party may be an attractive option, especially if is concerned with equity dilution; however, there are oftentimes rigid repayment legs and hard maturity dates in these agreements. As a result, this form of secured debt, is most appropriate for businesses who know with a high degree of certainty that the revenue generated from sales will be sufficient to repay this secured debt and that the business has enough liquidity to absorb standardized payment schedules.
In its basic form, equity financing simply involves a business giving some form of ownership rights to an investor in exchange for capital. Equity in a business set up as a corporation is represented as shares of stock, whereas equity in a business set up as a limited liability company is represented as membership interest/units (or a similar term). While equity financing is often considered a very attractive vehicle for funding an early stage business, it does come with some important drawbacks that founders and their advisors should consider before offering equity. Most importantly, with each equity offering, founders are giving up control of the business and will be bound to provide certain financial and organizational information of the business to each equity holder. Additionally, absent a public offering, which can be expensive, or a crowdfunding sale, which is relatively new and not as well known, most equity financing conducted through private offerings are made to “accredited investors”, which significantly decreases the amount of potential investors.
Common Stock – is a form of equity (stock) that represents ownership in a corporation. Most Common Stock offerings are conducted through private placement offerings (i.e. an offering not registered and regulated by the Securities and Exchange Commission). However, a business can sell Common Stock in a public offering if it chooses to register the sale in an Initial Public Offering (“IPO”) or is already a public company and decides to engage in a new issuance. A business will typically sell Common Stock in a private placement, however, to certain angel investors and/or friends and family who are not as concerned with the protective provisions that Preferred Stock entails, or do not find the extra resources necessary to issue Preferred Stock justifiable given their respective investment. A Common Stock offering typically allows founders greater control over the business, so long as they do not sell enough shares to effectuate a change in control.
Preferred Stock – is a form of equity (stock) in a corporation that provides its holders with greater protections than holders of Common Stock, oftentimes over payment of dividends, payouts in a sale of the business, anti-dilution rights, voting rights, and/or tag-along rights. Since Preferred Stock carries these protective provisions, most Venture Capital firms (“VCs”) and Angel Investors will want Preferred Stock in exchange for their capital investments. A business that accepts financing from VCs and Angel Investors in this context should be mindful, however, that these types of investors will want additional input in how the business is ultimately run. A business may be required to obtain their consent for additional equity financings, key strategic company decisions, as well as give up board seats in exchange for the capital investments. As such, it is important that the business understand and appreciate what selling Preferred Stock means for the long-term health of the business and the continued involvement of the founders.
Convertible Notes/SAFEs – especially in early, pre-revenue businesses, both a business and its investors may find convertible debt instruments attractive vehicles to fund the business. A business may find these instruments attractive because, unlike a Common or Preferred Stock offering, it does not have to put a price on the value of the business and, assuming things go well, delay dilution conversations. Investors may find these instruments attractive because they provide greater downside protections in the event the business goes south (i.e. debt holders are paid out before equity holders in a typical wind up of a business) and typically have an upside into getting discounts in future equity offerings. These instruments typically originate as a debt offering, but, assuming certain events occur, convert into equity (in some form) of the business. The most common types are Convertible Notes and Simple Agreements for Future Equity (“SAFEs”), we are explained in more detail below:
- Convertible Notes – are promissory notes whereby an investor loans a business an amount of capital in exchange for the business’ promise to repay the note at a set interest rate on a certain maturity date or have the right to convert the loaned capital plus accrued interest into equity at some future date (typically at a discount). A business may offer a payout premium (typically a multiple of the principal amount) in the event the business is sold before the Convertible Note converts.
- SAFEs – are promissory notes that operate almost the same as Convertible Notes, but with an important distinction: they do not require the payout of principal plus interest at a set maturity date. SAFEs may be more attractive in the event investors have less concern about getting repaid on the note at a certain date and want, instead, to capitalize more on the future equity issuance.
Alternative Arrangements (Crowdfunding) – A business may elect to raise money through conducting alternative equity financing arrangements, such as crowdfunding. Crowdfunding is a relatively new concept that involves the issuance of small amounts of equity to a greater number of investors (typically non-accredited investors). Although there are both state and federal laws designed around crowdfunding, businesses may still be adverse to engage in this type of equity financing as it is relatively untested in the court system.
Special Considerations for Pursuing Financing
Before deciding how to fund a business or advise others on the process, there are a few key considerations to keep in mind:
- What type of entity is the business? Remember, most angel investors of VC funds find LLCs a less attractive entity type.
- How much outside capital does the business truly need to hit its next benchmark? If the business needs a small amount, consider whether taking on debt from angel investor(s) or a small bank or SBA loan are most appropriate.
- How will the business use the outside funding? Having a robust plan for how outside capital will be deployed in the business should be equally as important as determine how much is necessary.
- How much control do in the business to the founders want to maintain? Oftentimes, given the option between debt and equity, founders will make decisions depending on the amount of control they are willing to give up in the business.
- How will the business be valued in an Equity Financing? While most of the time, a business should keep its valuation high, it should also leave room for growth. Raising too much in an initial round of funding and valuing the business at too high a price will also require a much higher exit price, thus limiting the number of potential buyers. In these cases, many businesses find that the only way out is through an IPO.
No matter which funding option a business chooses, remember that there is no get-rich-quick scheme when it comes to building a successful business. Founders, as well as their advisors, should do their homework, understand the territory, and be honest about growth goals in the business. While there are multiple mechanisms businesses utilize in order to achieve their funding goals, understanding what is best for each respective business can be the dispositive factor in determining whether or not a business ultimately succeeds.
Note: This article was originally published on the NC Bar Association blog
Based in the Research Triangle region of North Carolina, Fourscore Business Law serves entrepreneurs and businesses in Raleigh, Durham, Chapel Hill, Wilmington, Charlotte and throughout the Southeast. We also represent venture capital funds and other investors who invest in companies located in New York, Silicon Valley and everywhere between. The idea of delivering maximum impact in a simple and succinct manner is what we’re calling the Fourscore Principle. And that is what Fourscore Business Law is based on. Our clients operate in a broad range of industries including tech, IoT, consumer products, B2B services and more. Questions? Shoot us an email or give us a call at (919) 307-5356. Your first call is on us.