03 Feb How To Capitalize A Business
How to Capitalize a Business
A business can be capitalized with either equity or debt financing. When starting a business, or when operating the business, owners need to determine how to balance these two options. There are advantages and disadvantages as to both, and this article will discuss those in detail below, along with a brief discussion of the meanings of equity and debt in a business context.
What Is Equity?
Equity is ownership in a company. In the case of a corporation, equity is issued in the form of shares (also referred to as stock); in the case of a partnership, it is issued in the form of partnership interests; and in the case of an LLC, it is issued in the form of interests. Essentially, though, all of these terms mean the same thing: they are all evidence of ownership in the company.
What Is Debt?
Debt is a loan issued to the company. The document that evidences the debt is a promissory note, which explains the terms of the loan, such as when the loan will be repaid and at what rate interest must be paid. As opposed to equity, lenders receive no ownership interest in the business. (There are exceptions, such as convertible notes, which are essentially debt that can later be converted to equity. These are common in more complicated financings, such as angel investor and venture capital financings.)
The following are the advantages and disadvantages as to equity and debt financings, respectively, from the perspective of the business owner.
The Advantages of Equity
-There is no need to pay back any money, including interest on a loan. Instead, the business can benefit from outside capital through issuing ownership interests to investors in exchange for their investment capital.
-Even if the business does not end up making adequate profits, in most cases it will not have to repay the investors.
-Without debt, more working capital is available for the business.
-Credit history is not always as important in securing equity investments (this is important if you are a small business owner without much financial history).
-Sophisticated investors in your business may be able to help you run the day to day operations of the business and offer their business experience and judgment, along with other complimentary skills.
The Disadvantages of Equity
-At least some control in the business is given up (unless non-voting shares are issued). In other words, the business owners will be married (from a business perspective) to the investors and will have legal duties and obligations to them, including taking their interests into account when making business decisions.
-In most cases, investors will be entitled to share in the business profits, and the investors will take a larger share of those profits than a lender would have in the case of a loan.
-In some cases, the equity may be considered a security and federal and state securities laws will have to be complied with. This means that a lot of paperwork will have to be completed, and many other legal requirements will have to be met. (In other words, it quickly could get expensive.)
The Advantages of Debt
-The business owners keep control of the business because they don’t have to give up ownership in exchange for the debt. (They may, however, have to secure the loan with collateral.)
-Regular and timely repayments can build business credit, which is helpful for future borrowing and insurance.
-Interest payments on debt are tax deductible as a business expense.
The Disadvantages of Debt
-Repayment will require sufficient cash flow, which may be difficult for a startup, especially a startup without much capital to begin with or without a viable product to sell.
-Too much debt will cause the business to be considered “thinly capitalized.” (In general, the IRS considers a business to be thinly capitalized if its debt to equity ratio is greater than 3 to 1 (or possibly 4 to 1). Another method to determine adequate debt to equity capitalization is to review the debt to equity ratios of other businesses in the same industry.)
-Taking on debt from friends and family and not being able to repay it may harm those relationships.
-If the lender required collateral and the business cannot pay on the debt, the business may lose the collateral.
-Small business owners and startups often are required to personally guarantee loans, which could make those owners personally liable if the business cannot repay the loan.
Most small businesses use a blend of debt and equity so that they can reap the benefits of both types of financing while being careful not to thinly capitalize the business. If the business is considered to be too thinly capitalized, then the IRS may treat the debt as equity and deny the attempted tax advantages of deducting the interest on the debt.
If you need legal assistance in deciding how to capitalize a business, or if you have any other legal questions concerning a startup or small business — especially if your business is in or around Portland, Oregon — please contact us.
Author: Andrew Harris
To continue reading more about the laws that might affect your business, please see the Articles page, or to simply see a list of helpful legal resources for Oregon startups and businesses, please see the Legal Resources page.
If you need assistance with a particular legal issue affecting your business — especially if your business is in or around Portland, Oregon — please contact us and we will get back to you as quickly as possible.