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Suppose you are the director and shareholder of your own company. So far, all your business’ growth is due to your efforts and money. Now that you have a proven track record of success, you are looking to expand your business. Perhaps you could hire more employees to improve efficiency or purchase a new machine to reduce long-term variable costs. First, however, you need to raise additional funds. At the startup stage, you have two options for raising capital: debt or equity financing. This article will explain the basics behind both kinds of financing and evaluate their advantages.
Presumptions
This article presumes you have already incorporated your business as a limited company, as it is the best business structure for raising capital.
It also assumes you have incorporated using the unamended model articles of association. Articles of association are the documents that lay down the rules for running your company. The default and most common option is to use model articles when you incorporate.
If you are unsure what sort of articles you have, you can check with Companies House to determine. Companies House is the public body tasked with regulating incorporated companies in England & Wales.
How to Finance
There are two primary ways of raising capital:
- borrowing money (debt financing); and
- issuing more shares (equity financing).
A third form, often called hybrid financing, combines elements of both, but is not discussed in this article.
Debt Financing
For most startups, debt financing will either take the form of a loan from a friend or family member or high-street bank such as Barclays or NatWest.
Debt Financing
Debt financing is more flexible than equity financing because it is governed mainly by the loan terms, rather than company law. This is because loans are essentially contracts between the borrower (your company) and the lender (the bank).
For most startups, your company will have two lending options from a bank:
- an overdraft facility; or
- a term loan.
Overdrafts for business accounts function as they do for personal overdrafts, where you can overdraw your account balance up to a certain pre-agreed amount.
Term Loans
A term loan is where a company borrows a fixed amount for a specified period and makes periodic interest payments in exchange. The entire loan amount may come due at the end of the loan or be repaid along with interest at certain periods, depending on the loan terms.
Banks usually secure the loan in two ways:
- fixed charge — where the bank obtains certain rights to sell tangible company property like buildings, machinery, or vehicles in the event of breach, restricting your ability to sell the property while there is a charge over it; and
- floating charges — rights over your company’s inventory but which permit you to use and sell the inventory so long as you make all payments.
In practice, banks may also seek a personal guarantee from company directors, especially for smaller companies. In effect, you remain personally liable for the debts of your company.
Covenants
Finally, you should be aware of covenants, which are obligations the loan terms impose on your company to act or not act a certain way. An example might be not to borrow additional loans without the bank’s approval.
Equity
Your equity in a company refers to how much of the company you own, which can be measured by shares. Your company’s share capital refers to how much money your company has raised by issuing shares. When you incorporated your company, you adopted a basic share capital, which for many companies is a single share valued at £1 (or one £1 share per shareholder).
As your company’s director, you can issue shares subject to your company’s articles. When you issue additional shares to other investors, you effectively sell ownership in the company. If you are the only shareholder of your company, you will lose a percentage of ownership. This is called dilution. New shareholders have certain rights, which you must keep in mind. Although these rights may be at odds with your rights as a shareholder, such as the right to be paid dividends on the company’s profit, you must ensure you do not treat them unfairly.
Additionally, it is possible to issue different classes of shares, such as ordinary shares versus preference shares, where each class has different rights attached to ownership.
Practical Considerations
In practice, you may consider issuing shares to friends or family in exchange for them providing your company with additional capital. Furthermore, if your company is of sufficient size and interest, you may become involved with a venture capital firm. In any event, any time you issue shares, you are selling ownership in your company. If you are the sole shareholder, this means you will lose a portion of ownership and, ultimately, some degree of control. In many cases, as a condition of the equity financing, your investors will want to be appointed on the board with you or ask you to enter into a shareholder agreement.
The amount you can issue each share for will depend on the company’s value. This value can be quite difficult to calculate, but in general, it should reflect your company’s:
- revenue;
- cash on hand;
- assets or intellectual property; and
- debt or liabilities.
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Key Takeaways
Raising outside capital is often necessary if you want to grow your startup. Debt and equity financing both have their merits and disadvantages. Raising equity often results in loss of ownership and control, but the capital is locked up and can be reinvested as you, the director, see fit. For debt, you must agree to and follow the loan terms, otherwise, the bank can enforce their security over your assets. But, on the other hand, you do not dilute your ownership over your company.
If you need help with parts of business law, such as how to finance the next stage of your company’s growth, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Borrowing can be a flexible way to raise financing for growth without sacrificing ownership, especially when interest rates are low. There are certain tax benefits as well.
At some point, nearly every successful company opens up its shares to outside investors because it provides immediate cash for expansion and no obligation to immediately repay the money. However, the downside is a diminished portion of ownership in your company at the shareholder level.
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