The following is a guest post written by Samuel E. Whitley, managing partner at Whitley LLP Attorneys at Law.
How to raise capital for your business is one of the most important decisions you face as a startup founder. Equity and debt are the two basic types of funding available to businesses. Equity financing consists of cash obtained from investors in exchange for a share of the business. Equity funding could come from angel investors, venture capital, or Crowdfunding. Debt financing involves procuring a loan to be repaid over time with interest. Banks and government agencies are the main sources of loans. Here are the advantages and disadvantages of each type of funding:
The Advantages of Equity Financing
- The biggest advantage of equity financing is that the investor assumes all the risk. If your business fails, you don't have to pay the money back.
- Without loans to pay back, you'll have more cash available to reinvest in your company. Your company could grow faster than it would if it were saddled with debt.
- A deal with a well-connected venture capitalist or angel investor often comes with other benefits, such as access to key business contacts.
The Disadvantages of Equity Financing
- You must share ownership and control of your company with your investors. You'll have to share your company's profits with the investors. You won't have the freedom to make decisions regarding your business without the investors' approval. You may not agree with the way they want to run your company.
- The only way to regain full control of your company is to buy out your investors, which will probably require you to pay them more than they originally gave you.
- It takes a lot of time and effort to find the right investors for your company. Ideally, you should choose investors who share your business vision and goals and with whom you get along.
- Raising equity capital is more complex than getting a loan. It requires compliance with numerous federal and state securities laws and regulations. You'll have to issue periodic reports to shareholders and schedule periodic meetings with them, which could add significantly to your overhead costs.
- You retain full ownership and control of your business, since the lender does not claim equity in the company.
- Once you repay the amount you borrowed plus interest, you have no further obligations to the lender, who has no claim on the future profits of your business. Therefore, if your company is highly profitable, you keep a larger portion of the earnings for yourself than you would if you had to share it with investors who have equity in your business.
- Interest on debt can be deducted from your business' taxes, lowering the cost of the loan to your company.
- Since debts must be repaid within a certain timeframe, you could be in a difficult position if your company experiences cash flow problems or does not generate as much revenue as anticipated. If your company can't repay its debts on time, you may be forced to liquidate assets or shut down your business altogether.
- You could be held personally responsible for repayment of the loan, even if the formation of an entity such as an LLC creates a legal separation between yourself and your company.
- Debt could make it difficult for your business to grow, since you'll have to use part of the revenue to repay debt instead of reinvesting it in the company.
- If you carry too much debt, your company will be viewed as high-risk, making it hard to attract equity investors.
The decision to use equity or debt to finance your company ultimately comes down to how much control you wish to maintain over your business. However, an early-stage company that could take years to generate profit is likely to struggle with a high debt load. At the same time, startups have a hard time attracting venture capital until they show strong profit potential. Most experts suggest that businesses use both debt and equity, in a reasonable ratio. Consult with your accountant and attorney before making a financial decision.
WORKING WITH A BROKER-DEALER:
What to Expect and How to Enhance Your Next Capital Raise
 Securities and Exchange Commission, Report on the Review of the Definition of “Accredited Investor”, 48 (December 18, 2015).
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.