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The Pros and Cons of Equity Financing

When it comes to getting your small business or startup off the ground you have two options for financing (three if you count the lottery!):

  1. Debt financing is pretty simple. You may have used a similar model to pay for college, your first car, or that Xbox 360 you just HAD to have when you were 15. Debt financing means taking out a loan from the bank, or a private investor (AKA your friends, your parents, your friends’ parents, etc.) that you promise to pay back.
  2. Equity financing is pretty similar, except that you don’t have to “pay them back,” per say. Sounds ideal, right? Not quite. You DO have to pay your investors eventually — but instead of making monthly payments with interest, you’ll only compensate them if your business succeeds and you start making money. At that point, you give your investors a previously agreed upon percentage of your profits for the life of your business (unless you make so much money that you’re able to buy them out).

The Pros and Cons of Equity Financing

Debt Financing

The Pros The Cons

Company Ownership - Debt financing is pretty straightforward legally. The bank or investor does not “own” any portion of your business and they don’t have any say in your day-to-day operations. As long as you are making your payments on time, they will pretty much stay out of your way.

Interest –The most significant drawback of debt financing is that you have to repay the bank or investor with interest. (In fact, even if your parents are lending you the money, they are legally obligated to charge you interest for investments over 14,000, or else they will be required to pay a “gift tax.”)

Tax Advantaged - The interest you pay on debt financing is also tax deductible, and your loan payments are predictable from month to month (kind of like a car payment or mortgage payment).

Strict Lending Requirements – Debt financing can be difficult to get, especially for a startup company. Banks are wary of startups because many fail. If you are able to secure a loan, you’ll need to start paying it back right away, which immediately reduces the cash you have to work with on a monthly basis.

 

Liability - In many cases, a bank will ask for personal collateral to back a loan, even if you have an LLC (limited liability corporation). If your business doesn’t take off, you may be faced with liquidating (i.e. selling) personal assets such as your house, your car, your firstborn (just kidding) to pay back your loan.

With equity financing the pros and cons are reversed.

The Pros The Cons

No Interest Payments - You do not need to pay your investors interest, although you will owe them some portion of your profits down the road.

Giving Up Ownership – Equity investors own a portion of your business, and depending on your particular agreement, they may be able to have a say in your day-to-day operations, including how you spend the money that they’ve invested.

For example, if you think you need a BMW to meet with clients, and they think you need a used Honda – you’ll be in the Honda.

Depending on who your investors are, and how their vision for the business aligns with yours – this can be no problem at all, or a major pain in the you-know-what.

No Liability – If the business doesn’t succeed, the investors are the ones who take the hit – not you or your family.

No Monthly Payments - You probably won’t need to make monthly payments until you make a profit – which keeps more cash in your pocket while you get things up and running.

Finding Investors

So let’s say you decide debt financing isn’t for you — and you want to grow to your business with equity. What’s the next step?

First, you’ve got to follow the money — that means locating and soliciting investors.

When you think of investors you probably picture Wall Street and the crazy, hectic, confusing and loud stock market. Don’t worry. While an IPO (initial public offering) on the stock market IS one way to earn equity, it’s typically not feasible (or recommended) for a small startup business.

Instead, your investors will likely come in the form of friends, family members, business contacts, and potentially angel investors or venture capitalists.

Investment Networks

Angel investors (investors who support businesses they believe in, rather than businesses that promise the highest return on investment) and venture capitalists (your traditional “sharks”) can be located by word of mouth, and also through sophisticated investment networks.

An extremely popular network that you may have heard of is Kickstarter. You can join Kickstarter online, post information about your business plan, then wait and see if you get any bites from investors. Over the past year, websites like Kickstarter have become so popular that even celebrities are using them to fund TV shows, movies, and other personal projects.

One of the major benefits of investor networks are that they allow hundreds of people to make investments of varying amounts to your project – preventing you from being “owned” by one major investor. It also allows you to connect with investors across the country and around the world.

Startup Incubators

If you think your business could benefit from more than just cash, but also a little business advice or mentorship, you might consider a startup incubator.

Startup incubators are large companies that offer seed money, expert mentorship, supplies, and sometimes even office space in exchange for a share of company ownership (equity). Some of the most popular incubators today include Y Combinator, TechStars, 500 Startups, and Capital Factory, among many, many others. These incubators are sometimes specific to certain fields (technology or entertainment, for example), and others will accept applications for all types of ventures.

Because the value of startup incubators is so great, acceptance into them is typically VERY competitive across all industries. But don’t let that stop you – if you believe in your idea, chances are you can convince someone else to believe in it too.

Negotiating the Deal

Once you’ve located a good source of cash, you’ll need to negotiate a fair deal. We really, REALLY recommend that you enlist legal counsel whenever you’re negotiating an equity arrangement. Yea, yea, we know – lawyers are expensive. But trust us, they’re worth it. Don’t skip this step!

While it can be tempting to jump at the first offer you get (“this person is giving me cold hard cash – I’ll take it!”) the ins and outs of equity contracts can be complicated, and it’s important that you have an experienced professional looking out for your best interests, both today and down the road.

When negotiating equity, your foremost concern should be maintaining control of your business. If one day you become wildly successful and the profits start rolling in, you really don’t want to regret giving up 50% ownership of your business in exchange for $500 to buy an espresso machine, even if you do need the coffee to work long hours.

When you first meet with a potential investor, they will likely present you with a “term sheet,” which is just a fancy way of saying “this is how much I’ll give you in exchange for this percentage of your future profits.” A term sheet might also outline how much say the investor has in your business decisions, and what they will require from you on a monthly or quarterly basis to document your progress.

Now, just like you wouldn’t blindly accept the first offer on that old Chevy you sold on Craigslist, you shouldn’t accept a term sheet right off the bat either. A term sheet should be viewed as a starting point for the negotiation, NOT a final contract.

To negotiate a better deal (i.e. more money for you, less ownership for them) it’s important to understand how investors think: Investors typically base their offers on the level of risk they perceive for the specific investment. For the most part, if you can make your business appear less risky, you can often negotiate a better deal.

Two ways to make your business seem less risky:

  1. Present a sound business plan. Don’t just ramble off the top of your head – have something concrete, prepared in writing – with NO spelling or grammatical errors. Know what your goals are and be able to talk about them.
  2. Invest your own money. When you invest your own funds in your company, it shows the investor that you are confident the business will succeed, and that you are willing to do whatever it takes to turn a profit. The way investors see it, the more money you personally have on the line, the less likely you are to throw in the towel at the first major hiccup.