Savvy Ways Entrepreneurs Can Invest in Their Startups

Advantages and risks of lending money to your business

Q.  I know of someone who only invests in his various businesses through debt.  He pays himself back over time, plus interest.  What are the advantages of this?  I'm planning to start a consulting firm when I take early retirement from my current job.  I'll probably have to invest $20,000 upfront for office space, equipment and some support staff in order to compete on projects.    All I read about online is investing personal savings as equity.

A.   Raising money for a new business is always front and center in the minds of startup entrepreneurs.  The matter is not just about where to find funding but also how funds are invested in the company.

Entrepreneurs can invest personal savings in a company in exchange for shares of stock as an equity investment or lend the company money.  Of course, entrepreneurs can also do both at the same time.

From a conceptual standpoint, investing in a company through debt is a form of leverage.  To the extent that the business is able to steadily pay back the loan, the owner's investment risk goes down.  Further, at the same time the owner is building the value of the business, the returned funds can be put to work in other investments.

I suspect your colleague doesn't like locking up his money in various businesses for long periods of time.  This approach works especially well for business owners who don't expect to seek additional funding from independent investors or commercial lenders.

Angel and venture capital fund investors will typically force founding entrepreneurs to roll any debt position into equity.  They believe that entrepreneurs should not be paid back before investors.

Entrepreneurs should also expect that commercial lenders will want their loans to have a "first position" or "first lien" over the entrepreneur's personal loans to the company.  This means if the business should hit hard times, the bank will get paid back in full before the entrepreneur.  Some commercial lenders may also decline funding because the company's important debt-to-equity ratio is perceived as too thin to support additional debt funding.

Does this mean a startup entrepreneur should not fund a company with debt because of potential for additional funding requirements?  Not at all.  Debt-oriented investments give entrepreneurs flexibility.   Lending agreements can allow entrepreneurs to convert their shares into equity whenever they choose. Entrepreneurs can also lend money in the form of a line of credit and can raise and lower the debt outstanding to match business needs.

I called up Greg Rosica, tax partner with Ernst & Young, to talk about some of the fine points of funding a company through debt.  Rosica emphasizes, "If the investment is debt it should look like debt and act like debt.  All loans should be well documented and detail interest and repayment terms."

Here's some additional guidance from Rosica:

*   Financial statement preparation and tax reporting should be consistent and accurate.  This means, for example, businesses shouldn't deduct unpaid interest.  

*   Loan agreements can be developed for basically any type of business entity – a corporation, limited liability company or partnership.  Hire an attorney to prepare a formal note and a security agreement. 

*   Entrepreneurs should consult a tax advisor to understand their investment "basis" in a business and its implications for taking deductions for business losses.

It is true that meaningful profits can be made when an equity stake in a business multiplies in value.  Founding entrepreneurs, who already own a significant equity stake in a business, can use debt as a convenient way to leverage their investments even further.

Write to Susan at susan@takecommand.org for great funding tips designed for startup entrepreneurs, sole proprietors and fast growth companies.

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