Summary
- Businesses can raise funds through either debt financing (borrowing money) or equity financing (selling shares), each carrying distinct legal obligations and implications for ownership and control.
- Debt agreements typically include security arrangements and covenants, whilst equity financing may result in dilution of ownership and the granting of additional shareholder rights.
- Shareholders hold enforceable legal rights, including entitlement to dividends and the ability to take legal action if their interests are prejudiced.
- This article is a plain-English guide to debt and equity investment options for Australian business owners, covering the key legal considerations of each financing method.
- It has been prepared by LegalVision, a commercial law firm that specialises in advising clients on business financing and corporate law.
Tips for Businesses
Before raising funds, identify whether debt or equity better suits your goals. Debt preserves ownership but creates repayment obligations. Equity provides capital without repayment but dilutes control. Review all proposed terms carefully, including security agreements, covenants, and shareholder rights, before committing to any financing arrangement.
Businesses raise money in two ways: by borrowing it or by selling ownership. Understanding the difference shapes every major financing decision a company makes. This article will provide an overview of the two main ways you can invest money in a business: debt and equity investments. It will also explain the key legal implications for the different kinds of financing.
Learn how to meet your directors’ duties and ensure compliance with LegalVision’s free UK Board Reporting Toolkit.
Overview
It is helpful to understand who is who in a debt or equity transaction.
Your particular objectives will differ depending on if you are:
- the one making the investment in the business; or
- the owner of a business hoping to raise money.
Regardless of your position, you should understand the interests and objectives of both parties.
The Business Owner
As a business owner, you are likely hoping to raise money to grow your business.
For instance, perhaps you want to scale up the size of your operations to cut costs and grow sales. Or you may want to:
- buy a piece of equipment;
- move into a new market; or
- distribute a new product.
Alternatively, you may have a large payment coming up that you need help meeting.
Unless you have a substantial sum of cash lying in reserve, you will likely need to raise money from outside investors. Your two main options are:
- to borrow money (raise debt finance); or
- to sell shares in your company (raise equity finance).
The Investor
If you have excess cash lying around, it is always sensible to put the money to work by investing.
There are many ways to invest your money. One of them is by investing in private businesses (rather than public companies). However, for the vast majority of non-professional investors, investing in private companies is risky because it is largely unregulated.
That said, those who invest in private businesses do so by either:
- lending money to a company (debt); or
- buying shares in a company (equity).
Debt Financing
Legal Overview
Legally, debt refers to a certain kind of contract between two parties.
In the context of debt financing, at its simplest, a debt agreement is where the investor promises to give the company a certain sum of money in exchange for the company promising to pay the money back, usually with an additional amount (interest).
If the company does not pay the debt back, in theory, the investor (also known as a lender, noteholder, or creditor) can ask the court to make an order requiring the company to make a payment (a debt order).
But, if the company has no money, not even a court order can recover the money. Therefore, most debt financing seeks to improve the position of the debt investor so that they will only lend if certain conditions are met.
Terms of a Debt Agreement
Therefore, most debt agreements contain additional terms, usually in favour of the lender. The two most common terms are:
- security agreements, where you agree to transfer the legal right to a piece of property to the lender if you default (breach the debt agreement) on your business loan; and
- covenants, which are promises to do or refrain from doing something, such as taking out additional loans or failing to generate a sufficient amount of cash over a specific period.
Call 0808 196 8584 for urgent assistance.
Otherwise, complete this form, and we will contact you within one business day.
Equity Financing
Equity is a measure of ownership in a company, which you can measure by shares. Your company’s share capital refers to how much money your company has raised by issuing shares.
If you raise money through equity financing, you are effectively selling ownership to another person in your company.
In exchange for owning shares in a company, the equity investor will either want the value of their shares to grow so they can sell them later, or for the company to increase its profitability and pay them dividends.
Convertible Notes: A Hybrid Option
Some early-stage businesses raise money through convertible notes, which sit between debt and equity.
A convertible note starts as a loan. However, instead of being repaid in cash, the amount owed converts into shares at a later date, usually when the company completes a larger funding round. This allows the investor to participate in the company’s growth without requiring an immediate valuation of the business.
From the business owner’s perspective, convertible notes are often quicker and cheaper to document than a full equity raise. From the investor’s perspective, they typically include a discount rate or valuation cap that rewards early investment.
Convertible notes are increasingly common in startup financing in Australia. If you are considering this structure, get legal advice before issuing one. The conversion mechanics, interest rate and trigger events need to be clearly documented to avoid disputes later.
Practical Considerations
Shareholders hold certain legal rights. For instance, if you usually pay yourself through a dividend issuance, you will have to pay the same amount per share to your new shareholders. However, if you prejudice them in any way, they can take actions against you and your company.
For many companies issuing their first equity raise, their equity investors will usually want additional protection. This can be by:
- being appointed as a director so that they can control the day-to-day operations,
- being issued different share classes; or
- drawing up a shareholder agreement setting out additional rights.
Therefore, this is one of the key disadvantages to equity financing: by selling ownership, you also lose some control over your company.
Key Takeaways
Debt and equity are the two fundamental ways people invest in companies. A debt investment is a contract between a company and the investor setting the terms of a debt issuance (usually a loan). This contract obligates the investor to provide the company with a sum of money in exchange for the company promising to pay the money back plus interest and abide by the other terms of the loan. An equity investment is the purchase of shares of ownership in a company. Shareholders are entitled to share in the profits of the company, either directly through dividend payments or indirectly by later selling the shares at a higher price than they bought them for.
LegalVision provides ongoing legal support for businesses through our fixed-fee legal membership. Our experienced corporate lawyers help businesses manage contracts, employment law, disputes, intellectual property, and more, with unlimited access to specialist lawyers for a fixed monthly fee. To learn more about LegalVision’s legal membership, call 0808 196 8584 or visit our membership page.
Frequently Asked Questions
What is the difference between debt and equity financing?
Debt financing involves borrowing money that must be repaid with interest. Equity financing involves selling shares in your company to raise funds. With debt, you retain ownership but take on repayment obligations. With equity, you gain capital but give up a portion of ownership and potentially some control.
What is a security agreement in debt financing?
A security agreement gives the lender the legal right to a specific piece of property if you default on the loan. It improves the lender’s position by ensuring they have recourse to recover their money even if the company cannot meet its repayment obligations from available cash.
What rights do equity investors typically receive?
Equity investors may seek appointment as a director, different share classes or a shareholder agreement setting out additional rights. They are also entitled to dividends on the same basis as other shareholders holding the same class of shares, and can take action if the company prejudices their interests.
What are covenants in a debt agreement?
Covenants are promises included in a debt agreement requiring you to do or refrain from doing certain things. Common examples include restrictions on taking out additional loans or obligations to maintain a minimum level of cash flow. Breaching a covenant can constitute a default under the agreement.
We appreciate your feedback! Request your free consultation now.
