Most businesses need cash from the outside for several reasons. First, most businesses need money in greater quantities than the founders have in the bank. Second, many business starters believe that putting any or a lot of their own money in the business clouds their judgment; instead, they prefer to use other peoples’ money. Third, even if the business is profitable, cash could be needed because of seasonal or cyclical cash dips.

When people invest in a company, they expect to get something in return.  What they get for their money is either Equity or Debt.  Let’s talk about the difference between the two.

Equity financing is money (or property) that someone gives you for a piece of ownership of your company. Equity investments are often funded by friends, relatives, employees, customers, or colleagues. However, the most common source of professional equity funding comes from private equity firms. Equity is governed by a purchase agreement and agreements among the owners of the company.

Debt is money that has to be paid back, usually with interest. It can come from friends and family or complete strangers, as well as banks, credit unions and credit card companies. Debt is usually governed by a loan agreement and a separate promissory note.

You can’t talk about 21st century start ups without mentioning bootstrapping. “Bootstrapping” is starting and operating a business using a slight amount of your own cash and then only expanding when and if there is enough cash from operations. Bootstrapping is a fantastic way to start a business. You don’t mess around with investors, you keep control and you take the business higher and higher only when you have proven your concept. Eventually, capital needs may force you to abandon bootstrapping. If you want to bootstrap, you should still treat yourself as an investor. Record your investments in a stock register. If you loan money to your company, have your company give you a promissory note in return. Your company is not you – it is a separate entity, with separate risks and exposures, and should be treated separately.

Advantages Disadvantages
  • No personal guaranty
  • Could be a bigger amount than debt
  • Usually no obligation to pay back the investment
  • Investors often join Board, providing expertise and counsel, as well as discipline
  • Securities Laws are a painful web of red tape
  • Equity will dilute (reduce) your total ownership in your company
  • Investors often join Board, providing expertise and counsel, as well as discipline
  • Investors have a right to see the books and records of the company at their request
  • You will have “fiduciary” duties to your investors (like ethics and diligence)
Advantages Disadvantages
  • You don’t have to give ownership in the company in exchange for the money
  • The bank probably won’t join your Board and they pretty much stay out of the running of your business
  • You don’t have to give them a cut of your profits
  • You don’t have to give them a cut of your losses
  • You repay the loan over time – once it’s repaid, your obligations are over
  • You may be able to deduct your interest payments as a business expense
  • The people who lend money are usually easier to figure out than people who buy ownership in your company
  • Remember Goodfellas – “fuck you, pay me”; even if you don’t have the cash, or you need your cash for payroll or anything else, you have to pay the bank, on time
  • Your lender will probably stick “loan covenants” into your loan contract that say that they can call their loan if you get certain bad financial results or do something major without their approval
  • Your lender may demand you sign a personal guaranty

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