How Should You Finance Your Small Business – Debt or Equity?
Often the fact that an influx of capital is needed is not a hard question to answer. It’s generally plain to see based upon a simple review of the business’ financial requirements. The real question lies in how the business plans on taking on the extra capital. Typically this question revolves around whether the business take on financing via debt or equity?
Equity financing is when an investor invests money into the business in exchange for a specified equity stake. The main benefit of equity financing is that the business doesn’t have to pay the investor back. This is what makes equity financing so attractive to many business owners – it’s almost as if they are receiving ‘free money’.
Except that it’s not free money. Business owners are giving up a very real asset to the investor in exchange for their capital, that being the equity stake in the business. In essence, equity financing is a trade-off between the short-term financial needs of the business versus the long-term upside should the business continue to grow. Afterall, the investor in these scenarios is making a bet that their investment will be profitable one in the long run.
When considering taking on a new equity investment, business owners should consider two key points: (i) their willingness to transfer a portion the businesses’ future value; and (ii) their willingness to relinquish a certain level of control over the business.
Regarding the first point, business owners need to consider the value of the money they are taking on now versus what it will cost them in the future. Whereas the full cost of loans are more or less fixed (see below), the true cost of equity financing is not pre-determined. If a business really takes off financially after the equity investment, the business owner will lose out on the proportional amount of the businesses’ increase in value that was transferred over to the investor. This is a loss the business owner would not otherwise need to incur had they taken financing through debt. Ultimately, this may be a trade-off the business owner is willing to accept, but it’s always worth considering the true cost of taking on the financing versus simply the short-term. As for the second point, even though the investor will typically take on a minority stake within the business, investors often exert disproportionate levels of influence within the business via negotiated shareholders agreements they enter into as a condition to the financing itself. This is a manner for the investor to protect their investment. From the business owner’s perspective, it’s important to try and get a gauge of how the investor may be like to deal with on a continual basis. Are they easy to work with? Are they difficult personalities? These types of questions should be dealt with early on in the process because buying the investor out a later date will often require the business owner to spend more than they originally received.
Debt, commonly through the form of a loan, is the other form of financing that businesses will regularly enter into. Debt can be taken either through institutional lenders like banks or via private loans from individuals or other non-institutional lenders. One of the immediate downsides to debt financing, as compared to equity financing, is that debt needs to be paid back over a specified period of time with interest. Loans are often secured with collateral of the business and will also often include personal guarantees from the business owners. Therefore, there is a real financial risk in the event the business owner defaults on the loan. The bet the business owner is making when taking on debt is that they can pay off the debt. The risk of this particular bet varies from case to case.
The main upside of taking on debt financing is two-fold. First, debt payments are relatively fixed and, therefore, the true cost of financing is relatively pre-determined. Even in variable rate loans the costs of taking on money is more fixed than giving out an equity stake in the business. Second, lenders don’t take on an ownership stake in the business or otherwise have an ongoing relationship with the business. Once the loan is paid off, the business owner can operate freely without the need for additional influences on how to run the business. Furthermore, there is the additional benefit that, in many cases, interest payments on loans are tax deductible.
What’s right for you
Ultimately the form of financing to be taken depends on the circumstances of the business and the financing options being made available to the business owner. Each form of financing has its own benefits and drawbacks that need to be analyzed in light of the situation at hand. In general, it’s advisable to finance a business through a strategic mix of both debt and equity.
Speak to a lawyer at Kalfa Law for more information on your business financing options.
-Christopher Manderville, Associate Lawyer
Christopher’s practice is primarily focused on corporate-commercial law, including business formations, corporate reorganizations, shareholder agreements, commercial contracts, the purchase and sale of businesses, as well as secured lending transactions. Christopher graduated from Queen’s Law School in 2019. Christopher also completed his undergraduate degree at Queen’s University where he majored in Political Science and graduated as a member of the Dean’s Honour List. Christopher is a lawyer licensed to practice law by the Law Society of Ontario and is a member of the Canadian Bar Association.