I see a growing entrepreneur in my network – a female entrepreneur in the Philippines – which makes me even more excited to help her and mentor her to get to the next level with her business.
She asked me for help in deciding how to handle people interested to invest in her business, and what the difference is between an investment and a loan. I wrote it up for her – and figured may as well make it a blog post too.
Here’s my writeup in simple terms
I’ll also make this a blog post on mikesblog.com
The situation is:
My business is growing, and people are interested in investing.
Should I take a loan or investment, what is the difference?
There are a few things to consider here, and first you need to realize – in business it isn’t an exact formula – it is about negotiation and making a deal that is win win.
Loan:
This is a very straight forward idea. Basically, you can borrow money and make monthly payments back to the person / bank.
For example, you want to borrow 10,000 USD. There is an interest rate of 10%. You make monthly payments back to the person/bank for 10 years.
So those are the 3 main variables
A) how much you will borrow
B) your interest rate (the fee you will pay for borrowing the money)
C) the timeline of paying back, the term.
Benefits of a loan – it is very clear. They lend you money, you pay them back. You don’t need to have partners in your business and you can still own all the shares / the amount of shares you have.
Negative – if you don’t make more than 10% (or whatever rate you are paying) in your business growth, you are losing money. Hopefully your business is growing, and so long as you can make more back than you are borrowing.
Also, if the company fails, you still need to pay back? If it is a personal guarantee (you personally promise to payback) – this can suck if your company fails and you still need to pay back the person you borrowed money from. If its a company only loan – if the company goes bankrupt, you don’t need to pay back (but they will take over the assets, it depends on the deal but normally debt holders take over the company when you go out of business).
What is the person lending you money trying to do? If they believe in what you are doing, they may prefer to be an investor in the stock / equity – let’s talk about this next.
Equity Investment:
This is probably more common if it is friends / family / your network. They believe in what you are doing and want to be a partner / owner in it and enjoy the long term growth.
This one is much more intimate and complicated. They should realize investing in your small startup is very risky and if it fails – do you still need to pay them back? Normally – no – if they are truly investing in your startup (but many times if it is friends and family – they are investing in you) and it doesn’t work out – they lose their investment.
That is why sometimes raising money from friends and family is dangerous, and you need to be fully clear about the risks.
Of course we all want your startup to be worth millions, and they are hoping to enjoy that benefit by investing. So just make sure they need to realize the benefits on both sides.
If they don’t accept that – then it may be easier to make it a loan (option 1) and then you simply pay them back for the money they invested. If the company becomes a huge multi million dollar business (which I really hope) – they do not enjoy that – they simply get their money back and the interest rate earned.
Having investors join means they will have votes. How many votes depends on how many shares (there can be different classes of shares, but lets assume you only have 1 type of shares for today). You as the entrepreneur / founder probably still want to be the main boss and decision maker right? So try your best to keep 51% – each time you raise money – you will be getting more money – which is great – but it also means you will have more people with votes and input which can be distracting and even make you make decisions you do not like.
In the startup world – normally you try to raise money and “sell” 20 to 30% of your company for $X,xxx dollars. You tell your friends / family / network – you are looking to raise $100,000 usd for 20% of your company. You give the terms of what the shares will be able to do, and maybe you say you need to invest at least $10,000 USD to be an investor (meaning max 10 investors of 10,000usd). This means you value your company (100%) at $500,000 USD (100,000 times 5 to get 100 percent ownership). So you need to show how the company is valued at this amount, by showing prior sales and performance and show potential future growth opportunities.
One big question is – how will they get their money back? Two main ways
1) Selling their shares for a higher price later – hopefully your company grows! 🙂 It will! So then their $10,000USD investment in your company becomes 2x – so $20,000 USD – as now your company is worth 1 million USD – because your sales grew, your brand is more known, your team is better, and you have a bright future. They could sell it (to who? That is up to your terms when you sold to them), or they can sleep at night feeling they are richer now than before and hope it will be worth 2 million USD later and hold their investment longer.
2) dividends – you can pay out dividends on your company. This means the earnings you make from sales / from the business is returned to the owners. So for example, if your company earns a profit of $50,000 USD, you can pay that out to the owners.
If someone is a 10% shareholder, and you paid out a $50,000 USD dividend to the shareholders, they would receive a payment of $5,000 USD.
You can pay out dividends on your own schedule – monthly, quarterly, or yearly is most common. Just keep in mind this is more accounting and bookkeeping and the more investors you have – the more payments, etc.
Should you pay dividends? Good question. Well, adding shareholders will also start to put input on what they want. And what do you want?
If you believe your company can grow – you can convince investors you will not pay dividends. You convince them that the $50,000 USD in earnings is better off re-invested in to growing the company. Instead of paying that back to investors, you tell them it is better to put into opening more offices, hiring more workers, doing more paid marketing campaigns, buying more inventory, etc.
You should be clear about your dividend policy before you take investment, and make sure they are on the same page.
The biggest challenge with raising money from investors is are you on the same page. And how can new shareholders come in, and how can current shareholders sell out. Can they sell their shares to anyone, or do you have to approve who they sell their shares to. This is where arguments can come, and being clear at the beginning is the best formula for success.
I hope today’s blog writeup helped. If you’d like me to consider helping your startup, I do have consulting and angel investment opportunities – you can contact my blog team and let us know your opportunity.