This post is the third 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 Seeking Outside Investment here.
Once an entrepreneur makes the decision to seek outside investment in his or her company, the next question becomes what type of financing satisfies immediate needs without sacrificing the long-term vision of the company.
Generally, the decision comes down to whether the business will sell an ownership interest in the company (issuing equity a.k.a. equity financing) or whether the company will take out some kind of loan (debt financing).
Equity financing is a popular option for many entrepreneurs simply because the immediate costs are very low. However, issuing equity to finance your company also creates permanent burdens that may not make sense for all entrepreneurs.
Let’s take a deeper look into some of the advantages and disadvantages of equity financing so you can get a better sense of what might work best for your company.
Advantages of Equity Financing
One of the biggest advantages of issuing equity to finance your business is that the immediate costs are very low. Generally, when you issue equity to an investor in exchange for capital, the only up-front cost will be the attorney’s legal fees for drafting the stock purchase agreement – the cost of which will often be borne by the investor.
Once the stock purchase transaction is completed, the remaining costs are minimal, as equity financing does not involve interest payments or service charges. This is attractive to many entrepreneurs because it alleviates the cash flow concerns caused by interest payments and origination fees.
Take Facebook for example, a company that generated next to nothing in cash flow initially. Taking out a loan didn’t make sense because it was unlikely that regular interest payments could be fulfilled.
However, the company needed a cash infusion if it was going to reach the heights it has today. Peter Thiel, an angel investor, was willing to bet on the future profitability of the company in exchange for an immediate cash infusion, investing $500,000 for an ownership stake in Facebook. I think it’s safe to say that investment worked out well for both sides.
In addition to the cost advantages, equity financing presents opportunities for strategic partnership with investors who possess a complimentary skill set or years of relevant experience and expertise in your industry.
Furthermore, as an investor’s only return will be the increase in the value of your stock price or dividends from excess profit, equity financing aligns incentives and ensures that your investors have a financial incentive to contribute to the growth of your company.
Debt financers profit from interest payments and prioritize protection of their investment over the continuing success of your company. Equity financers don’t get paid unless your company reaches certain liquidity milestones and are therefore more committed to helping your company achieve maximum growth and profitability. However, as you will see below, bringing on co-owners can have disadvantages as well.
Disadvantages of Equity Financing
While issuing equity might make sense for your company, giving up part of your ownership interest to outside investors carries with it long-term burdens that should be considered.
The most glaring disadvantage to issuing equity is that giving up partial ownership of your company limits your financial upside in the company going forward. Simply put, every time you divide the pie (value of the company) into more pieces, your piece gets smaller.
Also of severe consequence is the fact that equity investors share in management authority. Giving up decision-making authority in your own company can be hard to swallow, especially to people that you probably don’t know very well. If you are not careful with the amount of power and ownership you give an investor, when owners and investors disagree about the direction of the company, the investors may try to force the owner out as CEO.
Furthermore, certain equity investors will insist upon contractual rights that potentially constrain your autonomy, such as liquidation preferences and anti-dilution rights.(Click here to find out what those are). This is why it’s important that any prospective equity investor is vetted to ensure alignment of your goals and vision for the company’s growth. (Forbes has thoughts on the matter, found here).
Determining what type of outside investment is best for your company is a big decision with lasting consequences, so it’s critical that you spend time assessing your business and its potential. If your company is at the point where you are actively seeking outside investment, you should contact a business attorney.
Check back next month as we take a deep dive into the pros and cons of using debt financing to fund your company.
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