Financing your business: Key clauses you should understand

Our legal expert explores the steps to take when bringing on board an external party (parties) to finance your operations

Many entrepreneurs begin the journey of running their own businesses with gusto. Yet, the core issue for almost every young business has been financing.

You set out and didn’t imagine there would be a mismatch between the projections in your business plan; or business isn’t picking up well. You realize that you need to inject more money as working capital or business is booming but you didn’t anticipate it and now you risk not being able to meet your orders.

This is a common narrative for most businesses. So how do you go about financing?

The quick answer friends would tell is to bootstrap some more or fundraise from family. However, this may not be an option and you need to bring in an external party (parties) to finance your operations. Financing usually will take three main formats: Equity, debt or a hybrid of the two.

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1. EQUITY

So after the hustle and bustle you have found an individual or entity willing to provide the much needed capital. How do you make sure that you access the money you need without giving away your baby that is the business? There is a very thin line between balancing the two. However, this is the crucial point where the business structure comes into play.

Assuming you have a limited company and a shareholding agreement in place. How do you decide how much to give away? Key components would be the valuation of the company as well as how well the company is doing financially so as to leverage. Still, there are key elements to look out for:

Decision making clauses: Most investors will usually come with a set of conditions and will want to have a say in the company as to how certain key decisions are made. Make sure you are not quick to give away too much equity to the extent of handing over the company especially if the capital needed is short term

Negotiate for more value outside the capital injection: If the investor is insistent on a larger equity than you are comfortable with then include clauses where you can derive more value.e.g access to the investor’s business networks, sponsorship to industry events etc

Exit clause: Clearly define how long the investor will hold the equity. Will it be for the continuity of the company or until the return on investment is achieved. If so, do they surrender all the equity?

RELATED: FOUR EASY SOURCES OF FUNDING FOR YOUNG BUSINESSES

2. DEBT

In the event that you cannot find an investor to commit some funds to the business and one opts for debt .One needs to look out for key clauses whether the debt is to an individual or a financing entity.

Repayment options: What is the duration of the facility? How much do you repay? What are the intervals of repayment? Is it monthly, quarterly etc?

  • Is there need for collateral or not? If there is collateral under what terms is it held? When will it be realised by the financier?
  • Is the interest rate fixed or variable? If variable do you have a duty to be notified before it is varied? What is the notice period?
  • Is there a moratorium or does is it begin to accrue immediately it is disbursed?
  • What happens in the event of default? How should the communication of default and the consequences of such default be done?
  • Is there room to restructure the financing in case one is unable to repay within the required interval?

3. REVENUE BASED FINANCING / HYBRID

This model involves sharing of revenue. The company agrees to share a portion of its revenue in exchange for the investor’s money. The investor will usually require a certain payout within the period of the investment.

ALSO BY THIS AUTHOR: COMMON LEGAL CHALLENGES STARTUPS FACE AND HOW TO DEAL WITH THEM

For example, he  may request for three  times the initial investment after a period of time. This is mostly where the investor recognises the potential of the business but does not want the perils of ownership. Clauses to look out for in such an agreement include: specific reference that the investor will have no shareholder rights and the definition of the periodic payments – are they to be made quarterly, every month etc?

Before deciding to pursue a certain model of financing arrangement, ensure that you weigh the pros and cons of each option. It is important to consult a legal professional to ensure that such agreements secure your interests.

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Caveat: Information provided herein does not constitute legal advice and should not be construed as such. For precise legal counsel please contact a professional.

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