(This post is part of my Small Business Startup & Survival Guide. You can catch up on the whole series here.)
In the U.S., it’s possible to start a business on a shoestring. This isn’t the case everywhere: some countries require that you have a minimum level of capital in order to open your doors. But in the U.S., ideas aren’t kept in check by lack of resources – generally, if you can dream it, you can do it. Of course, that doesn’t mean that it’s always easy. Financing a business at startup or at expansion does present challenges, especially in today’s economy. Figuring out how you want to finance your business in advance is key.
We typically think of two options for financing: debt and equity. Either can be accomplished by you, as the owner, or together with investors.
You already know what debt means: it happens when you borrow money that you will have to repay. In contrast, equity is the value of an investment in the company. It’s important to keep these concepts separate because they have different legal and tax consequences to you.
I know what you’re thinking: if it’s just me in the beginning, this doesn’t apply to me. You’d be wrong. If you’re financing your business on your own, you still need to figure out how to classify your investment. Keep in mind that in most cases other than a sole proprietorship, your business is a separate entity, so any contributions to and from the business do not simply pass easily back and forth from you to the business. If you loan money to your business, it’s considered debt and if you contribute money or assets to your business, it’s considered equity.
When you take money out of the business, the initial characterization affects the tax treatment. Repayment of debt is tax-free but associated interest is taxed as ordinary income. Similarly, return of capital is generally tax-free but gains or losses may be taxed as capital gain. Those are general rules: remember that facts and circumstances such as, for example, complete liquidation can produce a different result. With those general rules in mind, many business owners choose to categorize contributions as a mix of debt and equity at startup.
But what if money is coming from outside sources? In that case, the question of how to categorize funding takes on another level of importance.
Debt can come from a number of sources. You can opt for a traditional loan through a financial institution, get a credit card or line of credit, apply for microloans from business lenders or secure loans from individuals such as family and friends (be extra careful with this one).
Advantages of debt:
- One of the advantages of debt is that while the lender may have a claim to the assets in the business as collateral, the lender does not have an ownership interest in the business: your own ownership interest isn’t diluted. That also means that the lender doesn’t have voting rights or the right to claim future profits. If you can successfully repay the debt, the lender is only entitled to the principal plus interest during the term of the loan.
- On the tax side, the repayment of the principal is typically tax neutral (meaning that there’s no change) and interest on the debt is deductible to the company.
- It can be easy. If you have sufficient credit or collateral, it is generally not difficult to borrow money. Depending on how risky the lender considers your business, the terms of the loan are negotiable and you have some control over how much you can repay and the period of time you’ll have to repay.
Disadvantages of debt:
- You have to pay it back. I know, you already knew that. But with a bona fide debt, you typically have to pay it back even if your business isn’t able to translate the loan into success. Choose wisely when borrowing and pay particular attention to the repayment schedule: it’s not optional.
- You may have to co-sign. Other than a sole proprietor, your business is a separate legal entity. That means that you are not personally liable for the debts of the organization – unless you agree to be. This is where the lawyer in me tells you that you should, under no circumstances, agree to sign for your company’s debt. But the business owner in me knows that’s not always practical or realistic. So I’ll compromise and say this: read the loan agreement very carefully and where possible, try to negotiate a deal that doesn’t make you personally responsible. Better yet: check with your lawyer to find out exactly what your obligations will be under the agreement before you sign.
Funding your company with equity means that you are offering shares or interests of the business in exchange for cash. Those shares or interests could be offered to friends or families, potential business partners, employees or independent parties. Depending on the identity of the investors and your entity, there may be significant rules that you have to follow. Don’t ignore them, pay attention.
Advantages of equity:
- It’s relatively low risk. Generally, if you offer an investor equity in the company in exchange for cash, your out of pocket obligation ends there. If the company isn’t successful, you don’t have to pay the money back, nor do you have to pay interest.
- Investors may have more patience. Typically, someone who is willing to invest in a business understands that an investment is not a sure thing. Unlike a lender who will insist on an immediate return, an investor may be willing to give it some time.
Disadvantages of equity:
- There are lots of rules. Debt is generally governed by private contract but equity is typically governed by a body of state and federal laws. That makes it more complicated and often, more expensive at the outset. Depending on the level of financing you’re seeking – and the identity of the investors – you may be required to provide information about your business including financial statements and company practices.
- You may be giving up control. In exchange for cash, you’re offering up a share or interest in the company. Depending on the size of the interest, you will likely have to offer a share of profits and you may have to involve the investor in business decisions (silent investors exist but aren’t terribly common in the small business world).
- There’s no end date. With a loan, there’s a clear start date and an end date. When you offer up a share or interest in your company, the start date may be clear but there may not be a clear end date. In most instances, the only way to end the investor relationship is to buy them out: remember, however, they’re expecting to make a profit so a buyout could cost you.
So which option do I choose?
The question isn’t always up to you. You may be stuck with debt since investors can be difficult to attract and appease. Despite what you see on TV and in the movies, most startups don’t have venture capitalists and angel investors banging down their doors. Those that do will find that investors may want a significant piece of the business in exchange for financing.
The type of your business may also affect your course of action. Since S corporations have limited flexibility and restrictions on ownership (both in terms of numbers and identity of shareholders), investors aren’t big fans. Ditto for Limited Liability Companies (LLCs). While both entities can be converted to a more favorable choice, the conversion can be expensive and carry other consequences. Far more attractive to most investors is a C corporation. In fact, many venture capitalists and angel investors will only do business with C corporations. When it comes to foreign investors, it’s almost a certainty that a C corporation is preferred: most foreign investors can’t own shares in an S corporation and the pass-through tax treatment of the LLC is not favored due to mandatory withholding.
What if I don’t like either choice?
As the small business community changes, so do the available options. One option available to startups and existing businesses is crowdfunding. With crowdfunding, rather than seek significant funds from one source, a business seeks funding from several sources, often over the internet. There are a number of platforms available to make this happen, like Kickstarter and GoFundMe. A successful campaign – like the one for the brewers at Stable 12 – can ignite a startup or energize an exiting business.
A word of caution: don’t go to the well too often or without a plan because it can send the wrong message. I recently ran across a small business that was on its second unsuccessful crowdfunding campaign for a relatively small amount of money. The message that business was sending to its customers? It couldn’t pay its bills. Funding shouldn’t be about keeping the lights on but rather taking the next step. If you have crowdfunding questions, check with your professional team, including your corporate attorney and your accountant, before you act.