Capital comes in two forms: debt and equity. Each option has pros and cons, discussed in more detail below. At a high level, debt financing means your company does not give up any ownership (equity) for the money it receives. Of course, your company carries the debt on its books and must pay off the debt. Equity financing generally requires that the owners of the company give up some of their ownership in exchange for cash or property. While this means there is no debt to pay back, it means the original owners own less of their company.
Different scenarios call for raising capital by debt financing and equity financing. Spengler & Agans can help your company weigh your options. Let’s explore each type of financing in greater depth.
When a company opts for debt financing, the most common sources are a bank, family members, or close friends.
It may make sense for your business to look to a bank for financing. After all, not everyone has family or friends who can loan them money, and banks are currently sitting on a lot of cash—looking for businesses that appear to be a smart bet (although the lending climate can change in a heartbeat). Banks have deep pockets, and they may be your only option.
It must be said that securing a loan from a bank can be annoying and time consuming. The bank will want to see financial records, including tax returns for both the business and you, personally. Most banks demand a minimum of two solid years of financials before even considering a loan to your business. In addition to the standard promise to repay the loan (called a promissory note), the bank will also likely require that the business owners sign personal guarantees—meaning that you, as an individual, will be on the hook to pay back the loan even if the business fails.
Borrowing money from family or friends also has advantages and disadvantages. On the upside, there are fewer formalities when borrowing money from family or friends, and the cost of capital is lower in several meaningful ways. First, by borrowing from friends or family, you avoid lending fees charged by banks. Second, family and friends rarely require a personal guaranty, meaning that you don’t have to expose your personal assets to secure the loan. Third, the interest rate you pay your family and friends can be lower than the amount charge by the banks. You actually will want to make sure the interest rate is not too low, or else the “loan” from mom and dad could look more like a gift in the eyes of the tax authorities. The minimum allowable interest rate is determined by the government by the Applicable Federal Rates (AFR).
Of course, borrowing money from family or friends also has its downsides. The most obvious risk is that you may expose personal relationships to unwelcomed stress relating to the success of the business and the personal finances of the lender. If the business cannot pay back the loan, the personal relationship may be forever damaged. Or if the lender’s financial situation changes for the worse, the lender may ask for repayment of the loan sooner than is possible for the business. It may sound like overkill (and require uncomfortable conversations), but you will want to make sure you properly document loans received from family members or friends.
When a company looks to raise an equity round of financing, the options again include family and friends, as well as angel investors, early-stage venture capital, and private equity firms. Though surprising for some people to learn, some of the same legal formalities apply no matter where you raise equity-financed money—whether from family and friends or from other unrelated investors.
In short, you will need to clearly document transactions anytime you accept money during a capital raise. There are various documents involved anytime you’re raising equity financing for your company. Some of the more familiar names include a stock purchase agreement (if your company is a corporation) and a unit purchase agreement (if your company is an LLC). Other documents typical when raising money include due diligence documents, investor questionnaires, and subscription agreements, among others.
Depending on the financial situation of the investors (whether they qualify as “accredited investors”), your company may have heightened disclosure requirements. The consequences for not properly documenting and disclosing the risks of a capital raise (also called a securities transaction) can be dire, including the forced return of all money raised. If you solicit money from investors in multiple states, you likely will need to file documentation with the SEC (Securities and Exchange Commission). These regulations are in place to protect vulnerable investors, but they come at a cost. Complying with SEC regulations presents a hurdle to businesses raising money.
Effective May 2016, new rules and regulations from the JOBS Act provide some increased flexibility to businesses seeking to raise an equity round of financing. The new rules allow non-accredited investors the opportunity to invest in startups through equity crowdfunding. Time will tell how dramatically the new rules will impact startup funding. As the avenues for funding grows more complex, it becomes increasingly important to seek the advice of a trusted advisor who can help you weigh your options.
Most angels and other early-stage professional investors will perform significant due diligence. This process includes looking at company’s financial statements and tax returns, as well as the backgrounds of key team members. You can expect extensive discussions between the investor and your company. You’ll also have to report to your investors until they are able to exit, an event that may not take place until many years down the road.
None of this is to say that raising money from professional investors is without its benefits. Your company can gain an advocate with significant industry experience, useful contacts, or both.
For family and friends, most of the same pros and cons apply to equity financing as debt financing. Personal relationships are at risk, and you’ll have someone looking over your shoulder (who may not be familiar with the startup world). Financial assistance from that wealthy aunt and uncle may very well not be worth it.