Which Form of Financing is Right for your Business?

When seeking investment capital, small business owners are often not aware of the different forms that capital infusion can take. Sure, there are loans and equity investments but is that all? And what are the pros and cons of each?

“The first thing to keep in mind is which is going to make you more comfortable?” suggests Andrew Sherman, a partner at legal firm Jones Day and author of over a dozen books on the legal and strategic aspects of business growth and financing, including Raising Capital: Get the Money You Need to Grow Your Business. “I’ve met people who are not comfortable owing anybody anything. However, if you’re the type of person who’s a complete control freak, and having a second person or third person who owns the company with you is scary, then maybe you need to turn to the debt markets.”

Here is a quick look at the terms and forms of investment small business owners should be aware of:

Common stock. This grants you ownership of some percentage of the company. However, it does not always guarantee dividends and in the case of liquidation, holders of common stock are compensated after investors who extended loans and holders of preferred stock — if there’s any funds left by that point.

Preferred stock. While the terms for preferred stock varies from company to company, its shareholders rank above common stockholders and it’s not uncommon for a dividend to be paid to owners of these securities. In that regard it’s almost a hybrid of debt (dividends paid) and equity (shareholders also own an equity position).

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Debt. This is simply a form of a loan in which interest is paid, such as a bank loan. “People would like to think the bank is an option, and it’s really not,” asserts Sherman. “Remember how volatile the credit markets have been the last five years. Some of the new lending standards do make it tougher for small businesses to get loans.”

Convertible notes. According to Sherman, this is the ultimate hedge for an investor. “If I say, I’m going to invest $1 million dollars in your new pizza chain. It’s going to start out as a loan, earning interest at 8%. At the end of three years, I can convert that $1 million to for example, 20% of the equity in the company,” says Sherman “Or I can have my $1 million repaid together with the 8%.” This is appealing to investors since they have the option to take the equity if the business takes off, and its valuation exceeds that $1 million, or take the cash if it doesn’t.

Term sheets. These outline the terms of the investment agreement. “It’s like a road map to tell you, the entrepreneur, what the definitive documents are going to look like,” says Sherman. It should also lay out how management will use the investment and what the investor expects with regards to regularity and detail of financial and operations reports. “A lot of entrepreneurs go into this process very blindly and very greenly, without experience. Getting good advisors, understanding the balancing of the needs between the investor and the entrepreneur is a critical piece of the process.”

To be sure, there are other forms of financing (asset based lending, factoring and financing tied to royalties) all of which should always be outlined. Sherman also recommends having a business accountant and attorney in your corner to go over everything in the term sheet.