Disclaimer: This article is for information purposes only and should not be considered as legal advice. It is strongly recommended that any prospective entrepreneur consult a lawyer in order to make informed decisions that could involve legal matters.
When starting a business, the owner of the business can obtain funds from a variety of different sources. In general, financing can be in the form of debt financing or equity financing or a combination of both. The different characteristics of each type of financing will be considered to achieve the right mix of debt and equity for each individual business.
A. Debt vs. Equity
An important distinction between debt and equity financing is that debt financing must be repaid, while equity financing does not necessarily need to repaid.
When a business obtains “Debt Financing”, the business is obligated to repay the principal and interest to the lender. The lender does not obtain an ownership stake in the business, nor does the lender obtain the right to manage the business or elect or appoint representatives to do so. The lender is entitled to be repaid its principal and interest, but is generally not entitled to receive a share of the profits of the business. Upon the winding up of the business, creditors are generally repaid in priority to holders of equity.
When a business obtains “Equity Financing”, the business owner(s) may be giving up some control over the management of the business. The equity investors will obtain an ownership stake in the business, as well as the right to participate in the profits generated by the business. As noted above, if the business is wound up, equity holders will be repaid their share capital and any remaining funds only after all of the creditors of the business are repaid.
Generally, the holders of equity in a business expect to have greater control over the business than the debt holders. In practice, however, the terms and conditions of a particular debt financing package may give the lender a large amount of control over the conduct of the business.
B. Types of Debt Financing
Debt financing can be “secured” or “unsecured.”
Debt is “secured” when the lender obtains security over business assets for its loan. Security usually includes the right to realize upon some or all of the business assets should the lender wish to enforce its loan. If the business is unable to repay the loan, the lender is able to be repaid (or partially repaid) by realizing on its security. Types of secured financing include asset based financing, mortgage loans, term loans, operating loans, instalment financing, certain leases and loans secured by accounts receivables.
Examples of unsecured debt financing include trade credit, loans from shareholders or employees of the business (although such loans can also be secured loans). Unsecured debt involves more risk to the lender of not getting repaid, especially in the case of an insolvent business.
The terms and conditions of any debt financing will vary depending on the type of loan, the risk involved for the lender, the strength of the business obtaining the loan, and many other factors.
C. Types of Equity Financing
Most businesses are organized as corporations, which issue “shares” as equity. A corporation can have any number of different types (called “classes”) of shares, with different rights attaching to each class. For example, the holders of separate classes of shares may be entitled to voting rights at shareholders’ meetings, or may be entitled to receive dividends (if declared) in priority to the holders of other classes of shares, or may be entitled to receive the remaining property of the corporation upon the winding up or dissolution of the corporation in priority to the holders of other classes of shares.
Types of shares in a corporation generally include “common shares” which generally give their holders the right to vote in most circumstances and the right to receive dividends, and “preferred shares” which generally do not give their holders the right to vote in most circumstances, but do give their holders the right to receive dividends in priority to the other classes of shares and the right to receive their share of the remaining property of the corporation in priority to the holders of the common shares. Of course, the particular rights attaching to each class of shares of any corporation must be separately examined in every case, and there are wide variations in the rights attaching to shares called “common” and “preferred” by different corporations.
Groups that provide equity financing include the initial business owners, venture capitalists, certain lenders and eventually the investing public for a public company.
Again, the terms and conditions of any equity financing will vary depending on the particular factors involved in such financing.
D. Mix of Debt and Equity
In certain cases the same investor may provide both debt and equity financing, for example in a “mezzanine” financing or when a lender obtains a “participation” stake in a business.