The materials in this guide mostly focus on raising equity capital; however, you should understand all capital options available to business owners before deciding on a capital strategy. The last thing you want to do is raise the wrong type of capital, only to regret it down the road.
There are two primary types of capital: Debt and Equity. Let’s dive in to each of these in more detail.
Primer on Debt
Debt is considered a cheaper form of capital than equity because it’s non-dilutive capital. Non-dilutive means you aren’t required to give up ownership in your company in exchange for the cash. Debt can be a fantastic option for business owners.
Debt lenders are risk-averse. They don’t expect huge returns, but they don’t want to lose money either. To prevent loss of capital, they require insurance in the form of collateral, liquidation preferences, and repayments. This insurance can make debt riskier than equity for small, growing businesses.
Here are the primary types of debt available to entrepreneurs:
An SBA loan:
The Small Business Association (“SBA”) offers a variety of loan programs to small business owners. You typically access this capital through local banks who administer these programs. The SBA website (link here) has a great deal of information on these types of programs. SBA loans tend to have more favorable terms and fewer restrictions than traditional bank debt, but the process for applying for these loans is not quick and not every business qualifies.
A CDFI loan:
Community Development Financial Institutions (“CDFIs”) are non-profit organizations that provide loans to help generate economic growth in disadvantaged populations. These loans generally have favorable terms, but not all businesses qualify for CDFI loans, and eligibility differs between organizations. For more information on CDFI’s check out the CDFI website here. For a searchable database of CDFI programs near you, check out this link. You can find even more info on CDFI loans here.
A line of credit:
A line of credit functions as a credit card for businesses. For companies who only need a small amount of cushion to cover a short-term gap in profitability or fluctuations in working capital, this could be a viable option.
A term loan:
A term loan is a lump sum provided to a business which comes with annual interest and principal payments. This is similar to a mortgage on a house, and the assets of the company are typically used as collateral to secure the term loan. If you don’t have enough business assets, lenders often require personal guarantees on the loan.
Venture debt is either a term loan or line of credit offered to startup business alongside equity from another investor. The key provision for venture debt financing is that the company has ample cash on hand and an investor who is capable and willing to contribute additional equity to the business.
Mezzanine debt has a higher interest rate but generally does not require annual principal payments. The debt is typically paid off in a lump sum at the end of a set term.
Convertible Notes are debt instruments that convert into equity based on specific provisions and timelines. These are common with startup companies who have limited traction and don’t want to place a valuation on the business.
SAFES are a relatively new invention by the folks at Y Combinator and are similar to Convertible Notes. SAFES allow startups to raise capital from investors for the promise of future equity in the company. This isn’t debt or equity, but it’s an IOU, and in our opinion, any IOU is a form of debt.
Primer on Equity
Equity is more expensive than debt because you give up ownership in your business in exchange for cash. However, equity doesn’t have cash interest payments or rights to liquidate the company (usually). You also get more support and advice from equity providers than you do debt partners.
The most important thing you need to understand about equity is that it has three different structures:
Common equity is what employees and founders of the business own. An all common deal structure means all investors are in the same asset class as founders. Upon the sale of a business, all owners would split the proceeds from the sale pro rata based on their ownership percentage.
Participating preferred is the most dilutive and expensive form of capital for entrepreneurs. The participating preferred structure means that an investor gets paid back a multiple of their original investment, then participates pro rata with all common investors in the remaining proceeds. Investors use this structure to guarantee returns for risky or underperforming businesses.
Convertible (or Non-Participating) Preferred
A convertible preferred structure is a middle ground between common and participating. Investors have the option to receive either a pre-negotiated preferred return or to convert into common and participate pro rata with common investors.