Cons of Equity Capital Financing
When starting or expanding your business, you have a choice between two types of financing: debt and equity. Debt financing involves loans from banks, finance companies, credit cards and investors. Equity funding involves selling a portion of your company to an investor or other firm. This is the normal form taken by venture capital companies that are mostly interested in cashing out at a profit through acquisition of your company by a larger enterprise or an initial public offering (IPO) of stock.
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Debt Financing
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Loans to start your company, purchase equipment, manufacture or buy inventory, mount a marketing campaign, finance receivables or finance payroll are all examples of debt financing. Equipment leases, mortgages on business real estate and loans to acquire another company are also debt financing. The major drawback is the repayment provisions, which can burden your company with hefty monthly payments. Some debt financing contains a provision for converting the debt to equity at some point in the future -- known as convertible preferred or convertible debt. The benefits include the ability to take the cost of financing as a deduction against your corporate income tax, but the main benefit is not having to give up ownership control of your company.
Equity Funding
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Any time you receive equity funding for your company, you are taking on a partner. An investment of money for stock in your company makes the investor one of the company owners, and depending on the percentage of ownership, the investor can have considerable say in how you run the enterprise. Venture capital firms often take at least two seats on your board of directors and dictate choice of management and direction of enterprise growth. The percentage ownership is a function of the amount of money invested relative to the total value of the company. Value is figured according to different formulas, but it includes the revenues, assets and projections of future value before and after the investment. If your company is valued at $1 million and you need an additional $1 million to fund a growth strategy, the total value of the company, after funding, will be $2 million. This means the investor owns $1 million worth of your company, or 50 percent. Generally, the investor will want at least 51 percent voting rights, arguing that without the money your company would not achieve its strategic growth goals. This is where you and your investor usually get into a debate over the valuation of the company, with you arguing for a higher valuation so you can retain voting control.
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Drawbacks of Equity Funding
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Equity funding is a fine example of being caught between a rock and a hard place. While it provides needed money that does not have a monthly cost, it dilutes the founders' ownership and often puts control of the company in the hands of the investor. In some cases, the investor's goal in acquiring voting control is to fire current management and replace them with the investor's selection. The investor may also liquidate the company or sell it to another enterprise. This is referred to as vulture capital. Even if the investor controls less than 51 percent of the voting rights, a large stakeholder can disrupt company operations through control of the funds since most equity investment deals provide for staged investment on a quarterly basis but voting rights are immediately granted. While it is easy to see why an investor would want some control of the company in order to protect the safety of the invested money and influence the potential profitability of the company, if the investor has an agenda that is at odds with the founders, equity funding can be a disaster.
Protections
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Your best protection in equity deals is a good attorney who writes a good contract. Important clauses in the contract include, but are not limited, to restrictions on sale of stock or company assets, restrictions on formation of outside deals, stipulations on the use of and control of the invested money, founder and management termination protections, non-compete and non-disclosure provisions. The investors generally present their own term sheets and contracts, but everything is negotiable. Even if you badly need the money, it is always best to walk away from a truly toxic deal.
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References
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