The structure of your investment deal depends on a few different factors. First, there are three types of investor funding: debt, equity and convertible debt. Then, within those broad categories, the structure of the deal depends on your business’s viability. The stage, size and industry of your business, as well as how much you are seeking to raise and the time frame will all factor into the deal structure. Here are some basics tips for understanding investment deals and their structures.
Three ways investors can fund small businesses
There are three main ways investors can provide funding to your small business: debt investment, equity investment or convertible debt.
With equity investment, an investor will buy a “piece of the pie,” or ownership stake in your business. For instance, an investor might provide $100,000 in cash for a 10% ownership stake, meaning they will receive 10% of whatever profits you make down the road. How you determine what ownership stakes are worth largely depends on your financial projections, balance sheet, assets and larger macroeconomic trends.
[Read more: A Guide to Raising Venture Capital Funding]
Debt investment is different in that an investor loans your venture money in exchange for eventual repayment of the loan, plus interest income. “Debt capital is most often provided either in the form of direct loans with regular amortization (reduction of interest first, then principal) or the purchase of bonds issued by the business, which provide semi-annual interest payments mailed to the bondholder,” described The Balance.
Debt investment is considered less risky for the investor. If your venture fails, debt investors recoup their investment before equity investors. However, debt investors also have no ownership stake, meaning if your business is wildly successful, they won’t see the same escalating profits that an equity investor will.
The third option, convertible debt, is a hybrid of debt and equity investment. Your business borrows money from investors under the agreement that the loan will either be repaid or turned into an ownership share at a later point. This conversion typically takes place after an additional round of funding or once your company reaches a certain valuation.
If you decide to use a debt investment, the deal starts with three things: the amount you’re seeking to raise, the rate of interest that you are able to offer and the time frame in which the loan will be repaid.
Deep dive: equity investment
Equity investment is a broad category, and investment structures take several different forms. Here are just a few common small business equity investment options:
- SBIC: The Small Business Investment Companies (SBIC) is a program offered through the SBA to provide venture capital financing to small businesses. It pools investor money from venture capital firms to invest in startup, possibly high-risk companies.
- Angel investors: Angel investors seek companies where they can not only invest, but also provide guidance and mentorship to make sure their ownership stake is profitable.
- Venture capitalists: Where angel investors are typically using personal funds (hence the insistence on providing guidance), venture capital firms will pool money from professional investors to grow startups and small businesses. Venture capitalists will usually seek a seat on your board of directors.
- Equity crowdfunding: Through a platform like Kickstarter, equity crowdfunding involves selling shares of your company to the “crowd” to raise money.
How do you know what shares of your company are worth? It’s best to work with a professional business valuation service who can tell you how many ownership stakes to offer at what price. But to estimate, take the total amount you wish to raise, and divide it by how much you, the owner, has already contributed. In this way, you can roughly project the portion of “ownership” available to offer equity investors. For instance, if you need $100,000 and you’ve already contributed $60,000 on your own, there’s 40% ownership available if you choose to rely solely on equity investment.
How do you structure debt investment?
If you decide to use a debt investment, the deal starts with three things: the amount you’re seeking to raise, the rate of interest that you are able to offer and the time frame in which the loan will be repaid.
In addition, most debt investment structures will need some collateral. Collateral is a concrete, sellable asset that your lenders can take if your venture fails and you are unable to repay the loan. For instance, a car dealership might offer the actual cars as collateral, or the mortgage on the dealership property in exchange for a loan.
“Lack of collateral doesn’t completely rule out the possibility of taking out a loan. But if you don’t have any collateral and you don’t plan on signing for the loan personally, your options are mostly limited to smaller loans—usually less than $50,000—that are supported by the U.S. Small Business Association,” wrote one expert.
[Read more: What is an SBA Loan?]
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