Starting and maintaining a company requires capital. One way of raising capital is through debt which is the process of raising capital by borrowing. Debt may take many forms including a loan from family and friends or getting a loan from the bank. In truth, many companies have a mixture of both so they most certainly are not mutually exclusive.

Another way to raise funds for your company is through equity financing. Here, instead of getting a loan and repaying principal plus interest, the entrepreneur offers a share of the ownership in their company to members in exchange for the capital.

DEBT

Debt financing may take several forms, from the loans from family and friends to bank loans or further to the issuance of a bond, debenture, or other debt security.

In some fortunate instances, the entrepreneur may not be liable to pay interest to their friends and family for the sums borrowed but in most cases there is an expectation that you will pay back the principal.

With bank loans, a borrower is certainly obligated to repay the bank the principal sum of the loan in addition to interest payable on the principal sum borrowed. Where bonds, debentures or other debt securities are issued, the bond or other holders become secured or unsecured creditors of the company and are entitled to the payment of interest and to have their loan repaid at the end of a given period in exchange for the funds.

One of the advantages of debt financing is that the owners do not have to give up ownership or control of the company. Once the debt is repaid, the relationship with the creditor ends.

It is also easy to predict and forecast expenditure as loan payments typically do not fluctuate, except for variable interest rate loans.

The downside, however, is that for extended financing, banks or creditors normally require assets of the company to be registered as security for the loan which may hinder the borrower’s ability to treat or part with that asset.

In some cases, the owners (shareholders) may have to offer their own personal assets as security for the loan and/or guarantee the loan.

Another downside is the effect that the obligation to repay has on cash flow. This becomes especially challenging in that in any business there may be a dip in cash flow or the sector as a whole may experience a downturn.

Debt financing can be long- or short-term. Short-term loans allow the company to repay the loan in the shorter timeframe. Long-term loans can allow for the purpose of building a new factory — where the entrepreneur knows that this will not generate revenue in the short-term and will therefore result in the need for a longer timeframe to repay the loan.

EQUITY

Unlike debt financing, equity financing involves an ownership interest in the company being purchased in exchange for capital. In this case there may or may not be a right to a return on the investment whilst holding shares.

From a couple hundred thousand dollars raised from friends and family, to large multimillion dollar initial public offerings (IPOs) resulting in listing on the Jamaica Stock Exchange, equity financing spans a wide range of activities. It can be the catalyst for companies transitioning from a private company to a public company or even a public listed company.

Giving up some control of the company means that investors also take the risk that comes along with the ownership of the company which may make the venture a less arduous task for the entrepreneur. Unlike debt, should the company become unprofitable or unsustainable, there is no responsibility on the company’s part to repay the money invested nor is there an obligation to issue a dividend to the shareholders. Consequently, more capital may be available from the company’s trading cash flow for reinvestment.

Generally, investors take a long-term view and understand that growing a company takes time; this is why equity investments are often referred to as “patient capital”.

The biggest disadvantage is that the entrepreneur often has to give up a percentage of the ownership of their company and therefore, profits — if any — will be shared. The entrepreneur will also have to consult with the new shareholders whenever making decisions that affect the rights attached to the shares.

Unlike debt financing, the investors are there to stay unless their shares are bought back by the company or otherwise sold. But if the company increases in value, the shares will also increase in value and consequently, the funds required to buy back shares may be more than the funds initially invested.

IN OTHER WORDS… debt financing which involves borrowing money whilst not giving up any ownership of the company and equity financing which involves issuing shares to an investor in exchange for capital are two ways for a company to raise capital.

It is up to the entrepreneur to determine which means is best for their company and which means of raising capital will raise the most funds and result in the least hindrance to the company’s growth and operation.

On a personal level, the entrepreneur must decide if they want a bigger piece of a smaller pie (or in some cases the entire pie to themselves) or a smaller piece of a larger and perhaps more appetising pie.

Bazil-Lee A Williams is an Attorney-at-Law practising at MH&CO, Attorneys-at-Law, a boutique corporate law firm. He may be contacted at legal@mhcolegal.com