Sooner or later, a business’ ambitions will reach beyond the pocketbooks of the founders, family, and friends, and outside capital becomes necessary to realize the venture’s potential. There are several ways to acquire capital, and each method has benefits and drawbacks depending on the business’ industry and stage of development. Choosing the right capital structure through a combination of financing methods is essential to bring in outside money while maximizing profitability, stability, and flexibility. Debt and equity are the tried-and-true methods of financing, but securitization is a relatively new way to access capital markets with significant advantages and risks. This series of blogs briefly introduces these financing methods, why and why not they might be appropriate for your business, and their legal implications. First, we’ll take a look at debt. Debt is borrowing money for a fee. The borrower receives a lump sum of capital in exchange for a premium returned over time or at a later date. Premiums can take the form of periodic interest payments, principle payments, or return of a larger lump sum at the date of maturity. If the business is a reliable borrower, debt can be structured so that the lump sum never has to be repaid. The debtor can just issue new debt when old debt matures, so the cost of acquiring capital can be limited to interest payments. Borrowing has several advantages for a business. Because debt service payments are generally fixed, any additional profit generated with the use of borrowed funds over interest payments is retained by the company. So when a business is generating greater return on its assets than the available interest rate, leveraging with debt will bring more capital into the organization and increase return on equity investments. Also, creditors generally have no legal rights that allow them to exercise influence over management, so management discretion is not eroded through debt. However, debt is risky, disadvantageous, or unavailable in a number of circumstances. Because debt payments are fixed, there is risk of insolvency when cash is tight; whereas equity investors are not entitled to regular payments. A strong relationship with the lender can afford some payment flexibility in tough times, but lenders must be paid to avoid bankruptcy. Thus, there is a margin of safety in how much debt a company can hold; cash flows should reliably meet debt payments, so this cash cushion should be larger in highly cyclical industries. Also, most lenders are risk-adverse, especially in this economic climate, and they want assurances that a business will repay. Just in case a business can't repay, lenders want the borrower to post valuable assets as collateral. This conservatism makes debt unavailable or prohibitively expensive to start-up companies because their short track-record means ability to repay is uncertain. Start-ups face higher interest rates or outright denial of credit. Furthermore, companies with little in the way of physical assets for collateral, such as tech companies, also struggle to finance with debt. For this reason, even an established tech companies like Ebay only raise capital through equity. If your company has reliable cash flows, tangible assets for collateral, and generates hefty returns with those assets, debt is going to be cheap and beneficial. But before you stroll into the bank, it is important that your business be established as legal entity that separates your business assets from your personal assets. Without the limited liability provided by a corporation or an LLC (limited liability company), a lender to your business can recover their investment from your personal assets like your home or car if your business fails. Having an attorney establish a limited liability entity and assure the terms of credit do not attach personal liability can avoid serious personal financial problems. This legal protection allows the business to benefit while limiting your personal risk. If you are willing to take personal risk in acquiring debt for your venture, credit cards, home equity loans, and the like are potential sources of capital, but if your business can’t generate returns to make payments, you will be facing personal bankruptcy. You should assess what rate of return the investment will generate, and there are business professionals that can help you make these assessments. But when your venture can only receive credit through personal borrowing, bringing in equity investors is probably the better financing option, and that is the subject of the next post in the series…