This post is the fourth installment of “Laying Down the Law” – a series where our attorney friends at Troxel Fitch give legal advice for budding entrepreneurs. View the previous post about the Pros and Cons of Equity Financing here.
Once a business hits the critical stage of growth where financing becomes necessary, the decision on how to obtain it becomes equally critical. We previously discussed the benefits and drawbacks of equity financing, which is where you exchange a partial ownership interest in your company for funding. Now, we want to discuss the benefits and drawbacks of financing your business through a loan, a.k.a. debt financing.
While debt financing can provide the cash infusion necessary to achieve maximum growth, it can also have serious consequences for the business if things go wrong. Determining whether debt financing is right for you comes down to the particulars of your business, your personal risk appetite, and your growth timeframe.
Advantages of Debt Financing
Debt financing offers considerable benefits to the entrepreneur who wishes to maintain full ownership of his or her business or is wary of sharing management authority.
In contrast to equity financing, debt financing doesn’t require the entrepreneur to exchange ownership for funding. Rather than profiting from the residual income of the company, like equity investors do, debt investors generally only profit from their scheduled interest payments under the loan agreement.
This means the potential upside for the entrepreneur remains limitless because debt investors usually have no right to demand a share of profits. Once you have repaid the full amount of the loan, including the interest payments, your obligations to debt investors are over, even if your company has exploded in that time from a startup to a Fortune 500 company.
Debt financing also imposes fewer burdens on the entrepreneur’s freedom to manage the company as they see fit. Debt investors will thoroughly vet your company before extending a loan and might impose certain restrictions on your ability to take out additional loans.
That being said, they will rarely impose major restrictions on your ability to manage the operations of the company. On the other hand, equity investors will want to have input on the strategic direction of the company, the management structure, and the company’s path to exit events.
For example, imagine you decide that you want to pivot your company into a new market that more closely matches your long-term vision, but the market is less profitable and has less growth potential. As long as this new market will still enable your company to repay its loan, a debt investor will have no reason to object, and likely no ability to stop you.
In contrast, an equity investor will want to fully maximize the value of their ownership interest in your company, and therefore will insist that you remain in the more lucrative market despite your personal vision. In this way, equity investors have more influence over your autonomy than debt investors.
For the entrepreneur who values singular decision-making authority, debt financing can be an attractive option.
Disadvantages of Debt Financing
Despite the advantages debt financing offers in terms of autonomy and upside protection, it can have severe consequences on the downside, the main two being of collateralization and the lack of guidance.
Because many startup companies lack a history of profitability, debt investors almost always provide “secured loans.” This means that you guarantee your repayment of the loan by granting your lender a security interest in a valuable asset.
In short, you grant your lender the right to seize certain property if you fail to repay your loan. This is called “collateralization,” and the asset subject to seizure is called the “collateral.”
Many early-stage companies do not have the assets necessary to secure a loan, so your lender will require that you pledge personal assets or personally guarantee the loan. If your company hits a rough patch, and the business defaults on its loan, you could lose everything
For example, imagine your company needs financing but has no valuable assets or history of profitability. It is extremely unlikely that anyone will give you an unsecured loan in this situation.
However, let’s say you own a house and have significant equity built up in your house. Now a lender may extend you a loan but will require that you secure the loan with your house. Thus, your home becomes collateral. If you miss a loan payment or otherwise default on your loan, your lender can foreclose on your home.
What started as only a little cash flow problem has now likely destroyed the business, your credit, and your life. For this reason, anyone considering debt financing would be wise to take into account the harsh consequences for missteps.
Second, debt financing, for better or worse, involves only money. Debt investors will issue your loan, monitor your payments, and otherwise leave you alone for the most part. They do not provide comprehensive guidance or planning.
They expect you to take their money, make it grow, and give it back – all on your own. If you fail, they’ll just take your assets and get their money back either way. An equity investor, on the other hand, is in the boat with you, and if your boat sinks, they will drown too. Therefore, equity investors have a serious financial incentive to bring all of their skills, wisdom, and resources to bear in helping your company succeed; if you don’t succeed, their money is gone.
For that reason, equity investors will often provide significant guidance and resources to the entrepreneurs in whom they invest. For inexperienced entrepreneurs or ones seeking strategic partnership, debt investors may not offer the level of support needed.
The choice between debt financing and equity financing requires a hard look at the strengths, weaknesses, opportunities, and threats to your business. Making the right decision can propel your business to success and prosperity while making the wrong decision can lay the foundation of your doom from the start.
It is important to ensure you are informed and prepared when making such a decision, and it is often wise to contact a business attorney to help you think through these things.
Such experts can also advise you on flexible lending instruments, such as Convertible Notes, which will be the subject of next month’s blog. Stay tuned!
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