Business Fundraising: Pros and Cons of Debt and Equity
Creating a successful business can be rewarding and lucrative. However, growing businesses face the challenge of raising funds to purchase the capital needed to turn a profit. Many approaches exist to fund a business, virtually all of which involve some form of debt or equity financing. Read on to see why you might prefer one form of financing over the other.
Debt and Equity: The Basics
If you’ve borrowed money for school or bought a meal with a credit card, you’ve already encountered debt financing. Financing a business with debt is no different: a lender – typically a private institution – gives you money (or credit) on the agreement that you will repay them by some future date (the “maturity” date). And, as with credit cards, lenders will charge your business interest on the outstanding balance of debt (known as the “principal”).
In contrast, equity financing never obliges your business to repay its investors. Instead, the investors become co-owners of the business in return for their investment. Co-ownership grants your investors control over your business and entitlement to the company’s profits for as long as they hold their shares. The amount of control and profit entitlement depend on the size of the investment compared to the existing value of your company.
Hybrids: Best of Both Worlds?
Debt-equity hybrid investments are unusual, though investors will commonly split their investments into debt and equity. Some investors offer convertible debt instruments, which involve extending credit to your business, but give them the option to convert the outstanding debt to an equivalent amount of equity.
The Pros and Cons of Debt
Debt financing is a great way to access funds without yielding any control over your business. Your relationship with the lender only lasts until the maturity date, or until you’ve repaid the principal plus interest.
A downside is that interest forces you to pay more than the principal is worth for the privilege of accessing funds now. Offering your business’ real property as collateral for the loan can lower interest rates, but less-mature businesses may struggle to convince lenders of their creditworthiness.
Another disadvantage is that owing regular repayments for a business that might not yet be liquid can strain its finances.
The Pros and Cons of Equity
Equity investors are traditionally wealthy individuals (“Angel” investors) or institutional investors (like venture capital firms). These entities evaluate your business’ performance to determine whether it represents a sound investment. Your business may benefit from the expertise and resources your investors bring to the table as co-owners, assuming you choose them wisely. Remember, accepting equity is a long-term commitment, making proper due diligence of investors critical.
Crowdfunding: A Modern Approach
An internet-era alternative is to crowdfund equity. Crowdfunding platforms like “Kickstarter” let users contribute small amounts that can amount to substantial aggregate funds. This can be an attractive option for newer ventures that haven’t built up the sales data to impress larger investors, though it doesn’t bring the resources and expertise that large investors can offer.
So, which is better for your business: debt or equity financing? There is no right answer, and your business’ needs, its development stage, and your own preferences should all influence your decision.
-Shira Kalfa, BA, JD, Partner and Founder
Shira Kalfa is the founding partner of Kalfa Law. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.
© Kalfa Law, 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.