Small Business Tips: How to Finance Your Venture
Equity, debt or convertible debt – That is the question
Before raising money, it's important to recognize all the available options for small business financing. What makes the most sense for you to grow your business: Equity, debt, or convertible debt?
Raising capital with equity – allowing investors to buy stock in your venture by giving them a financial stake in the future of the company – is a popular route many entrepreneurs take.
HOW IT WORKS
1. You set a specific dollar amount – valuation – for what your company is worth.
2. Based on that valuation, investors agree to give you money in exchange for a percentage of the business.
3. Investors receive compensation based on the percent of stock they own once you sell the company or take it the public market.
- Your cash can go toward the business, rather than paying back loans.
- Investors take on some risk and don't have to be paid back until you're bringing in revenue.
- Investors often have and can share valuable business experience and advice.
- Since investors have a financial stake in the success fo your company, they are motivated to see you succeed.
- Forbes contributor and growth consultant, George Deeb says: Equity financing has the highest legal bills and takes the longest time to close, making it the most complex small business financing structure.
- Once shares of your company have been sold, it's very difficult to get them back.
- You will most likely lose control of part of your board to your investors.
Debt-based fundraising – when money is loaned to you following an agreement that you'll repay it over time with an established interest rate is the form of small business financing most small businesses end up going with, according to Fundable.
It's also the easiest to understand.
HOW IT WORKS
1. You borrow money upon agreeing to pay it back with interest in a set timeframe.
2. You will also have to offer your lenders some form of collateral, which are liquid assets you will give up if you cannot make your loan payments.
- You will raise capital faster than with equity financing. This is especially true of small cash amounts.
- You can keep 100 percent of your company and 100 percent of the profits.
- Interest payments are tax-deductible.
- 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 to recoup the funds.
- Interest payments can become one of the company's biggest drains.
- Commercial lenders will demand small business owners personally guarantee the loan and offer personal assets as collateral, even if your company is structures as a corporation or limited liability company.
A convertible debt structure is a combination of debt and equity financing. The money raised is considered a loan, but at some future date the loan can convert equity if the lenders so choose.
HOW IT WORKS
1. 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.
2. The details of how lenders 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.
3. You will also set the valuation cap, or maximum valuation, at which lenders can convert debt into equity. If investors decide not to trade in their loan for shares at this predetermined valuation, they can no longer do so at a future date.
- Transactions costs are low and the process moves quickly.
- If you don't want to set a valuation, which involves a lot of uncertainty and risks for new startups, a convertible debt structure for small business financing makes a lot of sense, says Covestor CEO Asheesh Advani.
- Using convertible debt protects investors from dilution in future financing rounds.
- Investors are uneasy giving money without knowing the exact share of a company they will own, and you might have to offer steep discounts on equity to get them to agree to the terms.
- You m ay be forced to set a valuation before you're ready to avoid unaffordable loan repayments.