Jan. 2, 2023

This paid piece is sponsored by Woods, Fuller, Shultz & Smith PC.

By Max J. Donohue, associate attorney

Starting or growing a business can require a significant investment. When considering how to fund a business, there are several financing options to consider, each with its own financial and legal consequences. A company’s financing arrangements, or capital structure, can vary at all stages of the business life cycle. Most importantly, owners can gain control by understanding the basics of different financing methods that will help expand their company.

Self-funding 

Self-funding is the use of personal funds to help in the development or advancement of a business. This is the easiest funding method and can come in various forms. Ways to self-fund a business include, for example, utilizing personal savings, leveraging a 401(k), selling other investments — stocks, mutual funds, etc. — selling personal assets or accessing other similar cash accounts. This method is attractive because it allows the business owner to maintain sole control over the business or startup. However, this method can be challenging because readily accessible cash can be difficult to obtain, using personal funds may conflict with other financial goals or some may find the opportunity cost and risk of using personal funds too great.

Debt financing 

Debt financing is borrowing funds from an outside source with the condition to pay back the funds plus interest over a period of time or at a specific time in the future. Debt financing comes in various forms, such as bank loans, private investor loans, credit cards or government-backed loans. One advantage of debt financing is that it may be less expensive than other financing options. There are two reasons for this. First, debt financing does not require a business owner to forgo equity ownership in exchange for funds. And second, interest expense is a deductible expense and reduces a business’ taxable income.

A drawback of debt financing is that it must be paid back regardless of whether the business is profitable or not. In addition, debt may have certain restrictions, otherwise known as covenants, attached to it. The loan agreement typically outlines these and may involve distribution limitations, capital expenditure restrictions or certain financial condition requirements. Qualifying for a loan will depend on a number of factors, including, but not limited to, a business’ debt coverage ratios, collateral type and amount, market conditions and sometimes personal capital invested. Lenders often require a business owner to execute a personal guaranty in connection with the debt. This means the business owner is responsible for the debt payments irrespective of the business’ ability to pay.

If used appropriately, debt financing can be useful and attractive to owners desiring to maintain full equity control in a business. But if debt financing is used incorrectly or does not result in income-producing assets, servicing debt may be difficult.

Equity investors

Equity investors are individuals or groups who provide financial support to businesses in exchange for equity ownership of a business. Utilizing equity capital allows investors to participate in the business’ overall success alongside the business owner. Depending on the structure of the investment, equity investors also may provide professional or strategic guidance to the business.

The most significant downfall of equity investments is that the business owner will be required to reduce his or her ownership in the business and may be required to give up some control in the form of voting rights held by the investors. Even though an owner will forgo some ownership and may forgo some control of a business, partnering with equity investors can have a substantial upside. If investors are chosen carefully, an investor or investor group will provide the necessary capital or expertise to substantially increase the overall value of the business. These types of transactions are complicated and regulated, so they often require legal guidance. For example, some of the documents in an equity investment likely will include term sheets, private placement memorandums, stock or unit purchase agreements, amendments to corporate documents and filings with federal and state securities regulators.

Initial public offering

An initial public offering may be necessary if a business requires significant capital investment. An IPO is a process of selling shares of a business to the public in exchange for capital. This is a costly and time-consuming decision. However, it presents an opportunity to raise significant capital, provide notoriety to the company and potentially provide a return on investment for a business owner or equity investor. IPOs are often for companies with large enterprise value, strong cash flows and stable growth projections. Maintaining compliance while publicly traded is burdensome and can deter many businesses from seeking this financing. Publicly traded companies must adhere to various regulations and disclosure requirements established by the Securities and Exchange Commission.

Regardless of the financing method a business may want to consider or choose, Woods Fuller has the breadth of experience to guide and help. Woods Fuller can assist in decision-making and navigating all forms of negotiations for clients. Woods Fuller can provide expert legal services in all areas of capital formation and take a potential deal from term sheet to closing.

Visit woodsfuller.com to learn more.