When starting or growing a business, eventually many business owners encounter the need to secure additional financing. Knowing what type of financing is appropriate for a business can be challenging. While consultation with experienced business attorneys is always the preferred course of action, this article aims to provide some basic information on common forms of business financing.

Debt Financing

Debt financing is a term that may confuse the average reader, but chances are they have a better understanding of how it works than they realize. Anyone who has taken out a mortgage or car loan has engaged in debt financing.

For small business owners, the process of acquiring debt financing works in much the same way. Businesses apply for a loan through a bank or some other financial institution. While private debt financing (e.g. borrowing money from a family member) is possible, this method of financing is much less common than going through a bank or other public entity.

For young businesses that have not been around very long, the bank may check the personal credit of the business owner. For more established businesses, the bank will likely check the business’s credit score. This credit report is often compiled by a corporation called Dun & Bradstreet. Consultation with a Bay Area business attorney can help business owners ensure their records are complete and organized, and review types of payment terms and other due diligence items prior to starting the application process.

Equity Financing

Many people have at least a cursory understanding of how equity financing works because of the hit TV show Shark Tank. In the most straightforward type of equity financing, investors provide business owners with the requested financing in exchange for a percent stake or ownership in the business.

A major advantage of equity financing is that business owners do not have to pay the money back, which is not the case with debt financing. Your equity investors are part owners of your business and therefore have an interest in ensuring your business succeeds. After all, if you enter bankruptcy, your investors are not creditors; their money is lost, as well.

Depending on how you have structured your business, you may share an equal share of ownership between a small number of individuals. With equity financing, it is important that all current stakeholders understand how the dynamics of ownership will change by bringing in a new investor, who will be taking a percentage stake away from current owners. Often, consultation with an experienced business attorney is advised before entering the search for investors.

Convertible Notes and SAFE Agreements

Convertible notes are a type of short-term debt financing used in the early stages of raising capital for a new business. With convertible notes, investors provide loans to early-stage businesses. However, instead of expecting to be paid back the principal plus interest when the loan is due, the investor can instead be repaid in an equity stake in the company.

An alternative to convertible notes are simple agreements for future equity (SAFE agreements). SAFE agreements are legal contracts that hedge against the difficulty in placing a valuation on a new company. By delaying a valuation into the future and providing investors with an equity stake in that future valuation, SAFE agreements allow young businesses to attract investors early in the financing process. Early investors are buying a right to equity in the future, and often receive discounts and valuation caps as incentives for taking this initial risk.

Getting Professional Counsel

Understanding the right type of financing for your unique business needs can be challenging. For years, the professionals at Coepio Legal have been helping Bay Area business owners navigate the world of business financing.