Raising Funds for Your Business

Corporate Financing

When starting a business, an entrepreneur has many factors to consider and important decisions to make early on. Those decisions will subsequently dictate the company’s operations and ownership structure. One of the most fundamental decisions to make early on revolves around financing, and how investors will be compensated for their monetary contributions. There exists many different ways of structuring the deal, however suitability is pivotal because these early decisions have lasting repercussions.

As a general rule, money is invested in a company with the goal of generating additional revenue. Depending on investor preference, risk tolerance and company outlook, an investor may look to structure the deal as a loan, as an exchange for company equity, or both. Every situation requires its own unique solution, and we will now analyze in further detail the different possibilities.

Debt:

 

An investor may elect to structure the deal as a loan, with interest payments due on the principal loaned to the company. This type of deal shows up on the company’s balance sheet as a liability, and the lender does not acquire any company ownership by virtue of the loan.

This can be advantageous for a corporation in its infancy, as company equity does not have any true value backed by assets or cash flow. As a consequence, the business owner will generally have to give up a larger portion of equity to compensate for the inherent risks of the loan. The disadvantage is that as opposed to issuing equity and bringing on a partner into the business, this type of deal is such that money is owed to a third-party creditor, who’s interest is repayment, not necessarily long-term company outlook. This translates into a more structured and rigid payback scheme, with significantly less negotiating power than if the lender was a part owner as well.

Equity:

• Common Stock: Issuing common equity in exchange for financing is seen very often in everyday business, and constitutes the sale of a portion of the business in exchange for money, good or service. If we focus in on the financing side of this type of deal, it is imperative that a business owner, especially at the early stages of operations, have a long-term business plan to structure the sale of common stock accordingly. For example, a business owner should validate whether the long-term goal is the sale of the company, whether the investor should be issued shares with voting rights, whether compensation will come in the form of dividends, capital appreciation of common stock etc. The idea behind long-term planning is to define a payout structure that matches investor and owner’s objectives, and to avoid punishment at a later stages due to excessive dilution.  
• Warrants: A stock warrant is very similar to a stock option, in that it grants the holder the option to purchase securities (usually equity) from the company at a specific price in a fixed time frame. Warrants are often included in new debt issue to entice investors.
  A note of caution, warrants will generally be exercised if the value of the company's stock is greater than the fixed price contained in the warrant. Giving out too many warrants early on can dilute share structure later, once the company starts generating positive value.

Hybrids:

• Preferred Stock: Preferred shares are the form of equity most similar to a debt-loan, as it carries many of the same characteristics. Preferred shares dividends are paid out before any other class of shares, but rank after bonds (debt) during liquidation. They contain no voting rights. The price and dividend of a preferred share is fixed, and does not appreciate or depreciate in value as common stock does. A corporation can structure their preferred shares with numerous different features. The preferred shares may be cumulative (entitled to dividends for periods where dividends were omitted), callable (company can buy back shares at a fixed price by a fixed date) or convertible. These different options can be used to structure the right deal based on the company’s needs.

•  Convertible Debenture:
  A convertible debenture is a type of loan issued by a company that can be converted into stock. Generally, because of the convertibility option, the company will pay a lower percentage of interest on the loan, compared to if there was no option to convert.
  
  An important point to distinguish between a convertible debenture and a convertible bond is that the debenture is unsecured, meaning that in the event of bankruptcy, a convertible debenture holder would be paid out after other debt holders (bonds, loans etc.)
   

 

There are many ways to structure your business financing. The most important part of the question, however, is picking the right one to suit your needs. All of the above options can be individual solutions, or coupled together to meet the company and investor's needs. Briefly, here is a general list of pros and cons to the different forms of financing:

 

Equity Financing:

• Advantages
• Less risky than a loan, as it dos not need to be paid back
• Investors take a long-term view, and generally don't expect a return on their investment immediately
• More cash on hand for expanding the business
• No requirement to pay back the investment if the business fails 
• Disadvantages
• The required rates of return from investors may be higher than the cost of a bank loan
• The investor will require some form of ownership
• The business will need to consult the investor before big decisions (and potentially routine ones)
• It takes time and effort finding the right investor for your company

Debt Financing:

• Advantages
• The lender has no say in company operations, as there is no ownership
• The business relationship ends once the money is paid back
• The interest on the loan is tax deductible
• Loans can be short or long term
• principle and interest are known figures, making it easier to structure the business's budget.
• Disadvantages
•  Money must be paid back within a fixed amount of time
• Carrying too much debt is seen as "high risk" by potential investors, potentially making it more difficult to raise capital later on
• Assets of the business can be held as collateral to the lender.