Building and growing a business requires a lot of effort + a little luck + investment capital.
Effort is hard work over a period of time and luck is often a by-product of effort. This leave’s investment capital: deciding how to raise investment capital is not an easy decision. There is no one-size-fits-all approach to raising capital but having a good handle on what the options are will certainly assist you choosing the best alternative. There might even be options you didn’t know were possible, like drawing financing secured by private assets, taxed effectively.
Generally, investment capital can be raised in two ways. Your company can issue equity by agreeing to forfeit a share in the business for a capital injection or you can be loaned capital and increase your debt levels.
Equity Raising
Issuing new equity opens up the company’s share or ownership register too new and sometimes unknown business partners. It also dilutes management control. Start-ups should think very carefully about jumping too early into an unknown business partnership. If your growing business begins to look even moderately successful, offers for equity based partnerships should come thick and fast. Beg, borrow and scrape through the initial growing pains before considering an equity raising. Surviving the first few years will mean you get a lot more bang for your buck should the equity raising bridge need to be crossed in the future.
However, if your business has the opportunity to grow quickly, it may be necessary to raise significant capital to maximise this potential and take advantage of that market opportunity. It may be difficult to achieve this through debt financing alone. If so, you should view the equity raising as an opportunity to also lock in the right strategic partner. You might also consider equity terms like stapled options, vesting ownership and preferential equity rites.
Debt Financing
There are a variety of ways to access a loan for your business.
Overdraft
If you just need some buffer room to manage cash flow fluctuations, an overdraft facility provides flexibility for your transaction account to temporarily sit in arrears. Care needs to be taken as overdraft facilities are usually expensive and can sting you if you sit in the red too long.
However, if your cash flow concerns are minor, exploring overdraft options with your business banker might be a good place to start.
Director’s Loan
A director’s loan is capital loaned to the company by the director. Instead of just retaining company earnings, establishing a director’s loan gives the director greater capital redemption rights should the company go into administration or bankruptcy. However, the downside is that it will result in higher taxation if the director’s income, and so tax rate, is greater than the company tax rate.
When there are multiple directors care should be exercised if vastly different loan accounts accrue and the business suddenly becomes insolvent. This may result in an inequitable outcome for the director with the higher loan balance.
Business Loan
A business loan can come in many forms. It essentially involves your company taking on a loan from a bank (or other lender), where repayment obligations are reconciled against the businesses operations. Keeping the loan within a company entity can limit potential personal liability.
A business loan can have a variety of different features. It might be unsecured or issued contingent on security being offered via a mortgage on business real property or company assets. It could incorporate personal guarantees from directors.
If you are operating a business in a company structure, care needs to be taken on loan terms offered as providing a personal guarantee essentially circumvents the creditor protections of having a loan financed through company. Even without signing a personal guarantee, as a director of the company, you may become liable to creditors if your actions are deemed negligent.
As with any investment or loan, the greater the risk of you defaulting on your loan repayments, the higher the interest rate levied on the loan.
Personal loan
You can also fund business investment via a personal loan. Like a business loan, loans can be conditional on security and guarantees. Creative funding opportunities are arising in the peer to peer lending space.
One more traditional and cost effective methods of financing investment is by drawing down against the family home. If this makes you sweat a little, it should. You would be putting the family home on the line. But, because the security on the loan is so solid, the cost of financing is typically much lower than other methods.
Financing secured against the family home can also be achieved tax effectively via use of a debt facility. This allows separate lines of credit, which have different funding purposes, to be secured against a common security, or even bundled security like home and investment property. You can tax effectively redraw investment financing, secured against a private asset, whilst still paying off other private debt. A nifty solution if all the ‘ducks line up’ and the risk of the business investment is acceptable.
In summary
With any capital raising activity, the return on equity must exceed the cost of capital and typically by a material margin of safety. Be very careful about signing any personal guarantees and consider negotiating better terms by playing lenders off against each other. As a rule of thumb, you should only consider taking on personal liabilities to finance business investment when you have the lion’s share or equitable control of investment decisions.Speak to your accountant or financial adviser before committing to any capital raising decision.
About the author
By Matt Vickers CFP is Principal Adviser of Snowgum Financial Services
Any advice contained in this article is of a general nature only and does not take into account your circumstances or needs. You must decide if this information is suitable to your personal situation or seek advice.
