Introduction
Accounting for equity and debt financing is a critical part of any startup business's financial strategy. It is essential to properly identify, classify and account for both equity and debt, in order to ensure the financial health of the business. Knowing the relevant issues for startups can also help to mitigate losses and increase gains in the short-term.
In this blog, we will review the fundamental types of equity and debt financing and discuss some of the issues that startups typically face when accounting for these types of funding.
Review of Equity and Debt Financing
Equity and debt financing are the two main sources of external funding for startups. Equity is when a third party investor contributes capital to the business and receives ownership in return. This capital can then be used to develop products and other projects, as well as to cover day-to-day running costs.
Debt financing occurs when a third party lender provides funds to the startup and the company agrees to repay the loan, plus any interest, at a future date. Common forms of debt financing include loans, lines of credit and venture debt.
Relevant Issues for Startups
Accounting for both equity and debt financing is critical for a startup. It helps to ensure that the business is in compliance with accounting standards and regulations and helps to mitigate losses and manage cashflow. Below are some of the relevant issues that startups face when accounting for equity and debt financing:
- Accurately categorizing complex financial instruments as either equity or debt
- Recognizing and reporting equity and debt investments
- Reporting earnings per share and other required disclosures
- Calculating interest expense and other accruals
Key Takeaways
- Equity and debt financing are the two main sources of external funding for startups
- Accurately categorize complex financial instruments as either equity or debt
- Recognize and report equity and debt investments
- Report earnings per share and other required disclosures
- Calculate interest expense and other accruals
Equity Financing
Equity financing is a way of raising funds by selling equity shares in a business. It is similar to borrowing money from a bank, but instead of paying interest, the investor makes a profit from the appreciation of the company's capital.
Definition
Equity financing is the process of raising capital by selling shares of a company to investors. Equity investors, who are also referred to as shareholders, become a part-owner of the business and provide funding in exchange for the potential financial gain from any appreciation in the company’s value.
Types of Equity Investment
There are several types of equity investments available to provide startups with funding, including angel investment, venture capital, crowdfunding, and Initial Public Offerings (IPOs). Each comes with its own advantages and disadvantages.
- Angel Investment: Angel investors are wealthy individuals who provide capital to small companies with high potential. They often take an active role in the startup’s management and offer advice to help the company grow. However, they typically require a significant return on their investment, which can lead to a high cost of funding.
- Venture Capital: Venture capital is a type of equity financing raised from venture capitalists. It is a highly expensive option of funding, with venture capitalists typically expecting a return rate of up to four times their initial investment. The advantage of venture capital is that it often comes with financing and advice from experienced investors.
- Crowdfunding: Crowdfunding is the process of collecting many small investments from people online, usually in exchange for equity or a tax write-off. While crowdfunding is a great way to begin building an audience and obtain smaller investments, it requires a great deal of work to be successful.
- Initial Public Offerings (IPOs): An Initial Public Offering (IPO) is the process of taking a private company public and offering shares on the stock exchange. This can provide a large influx of capital but also comes with more regulation and public scrutiny. An IPO can be a lengthy process and require the company to meet certain standards.
Pros and Cons
As with any major financial decision, there are both advantages and disadvantages to equity financing. On one hand, it allows for larger amounts of capital to be raised, often from experienced investors. This can provide invaluable advice and mentorship for a fledgling startup. On the other hand, it can be costly as equity investors usually demand a portion of the company’s profits and a significant return on their investment.
Debt Financing
Debt financing is one of the most common forms of financing for startups because it is relatively easy to secure and repay. In debt financing, a startup will take out a loan from an external lender, such as a bank or a venture capitalist, and then pays that loan back in installments over time with interest. This arrangement is beneficial for startups because it allows them to access the capital needed to launch their business without having to give away equity stake.
Types of Debt Financing
Startups can choose from a variety of debt funding options, including bank loans, short-term loans, and venture capital debt. Bank loans are the most traditional form of debt funding, where a bank provides an agreed-upon loan to a startup in exchange for fixed periodic payments with interest. Short-term loans are similar to bank loans but are usually offered to startups that need a smaller amount of capital and have a shorter repayment window. Venture capital debt is similar to a bank loan but is typically used when a startup is backed by venture capital funds. In this type of loan, the startup promises to repay an agreed-upon lump sum with interest, and the venture capitalist typically takes a small equity stake in the company.
Pros and Cons of Debt Financing
Debt financing is a popular form of financing for startups because it allows them to access capital without giving up equity. However, there are some drawbacks to taking on debt as well. One of the main drawbacks is that debt must be paid back with interest. This increases the startup’s overall cost of capital, and could become a burden if the startup is unable to generate enough revenue to repay the loan.
In addition, taking on too much debt can limit a startup’s growth potential. Since loans must be repaid before any equity can be distributed, startups might be unable to reinvest the necessary capital into their own growth. This could be a problem for startups that need to scale quickly in order to compete.
Despite the drawbacks, debt financing is still a great way for startups to access the capital they need to launch and grow their business. By weighing the pros and cons of each form of debt financing carefully, startups can choose the option that best fits their needs.
Accounting for Equity Investment
When a startup company looks to raise capital, it often turns to both debt and equity financing. Both forms of investment require a degree of accounting. This article covers the ways a startup can account for equity and debt financing.
Share Structure
Before any financing can take place, the startup must decide on the share structure of the company – what kinds of stocks will they offer? The number of stocks and the breakdown of class of stocks can all play a role in how the company raises funds and what kinds of investors they attract.
Determining Closing Share Price
The closing share price of the offered shares is a crucial component to an equity investment deal. This price is the agreed-upon investment price for the stockholders and it should be determined before the investment is finalized. To ensure accuracy, a third-party evaluator should be hired to assess the true value of the stock, accounting for risk and market environment.
Recording Payables
Once the investment is fully closed, it must be recorded in the company’s balance sheet. This will involve accounting for any payables associated with the investment and should be done in accordance with generally accepted accounting principles (GAAP). Additionally, the company should track ownership of paying parties as part of their equity accounts.
When accounting for equity and debt investments for a startup, it’s important to ensure all documents are in order and each party has been properly compensated. By understanding the share structure and determining a closing share price, a startup can better navigate the tricky waters of such investments.
Accounting for Debt Financing
Raising capital is essential for any business, and startups are no exception. Understanding how to record both equity and debt accounts properly is essential for the health and future success of the company. In this section, the accounting for debt financing will be discussed.
Record Keeping
When financing a startup through debt, it is important to record each transaction in the company's bookkeeping system accurately. This includes the loan's original amount, details of the repayment terms and any account charges. Debts must be accurately accounted for to calculate the business's net worth and let potential investors assess the financial strength of the enterprise. As capital is accrued or repaid, all of the relevant accounts, such as cash or accounts payable, must be correctly adjusted and balanced.
Calculating Interest Expense
Interest accrues on the debt according to the loan agreement and it is important to record and keep track of the interest expense. For business loans, interest is typically paid on a regular basis according to the terms of the loan. At the end of the accounting year, the total interest expense incurred should be adjusted and the debtholder's account should be stated as the difference between the principal and the interest paid during the course of the year.
Handling Payments
Payments for debt financing must be handled according to the agreed conditions of the loan, usually as outlined in a loan agreement. Cash outflows are likely to include repayments of the principal, as well as fees, commissions and interest payments, if any. Entries into the accounts receivable and general ledger must accurately reflect the transaction between the startup and the debtholder
To avoid costly and time-consuming errors, startups should always consult with a lawyer, accountant or financial advisor prior to taking on any financing, so they can properly document, record and account for all transactions.
Complex Financial Structures
When it comes to the financial structure of a startup, there are many permutations and combinations that can be undertaken. In general, complex financial structures involve a combination of both debt and equity, which can increase their capitalization and ability to generate returns for investors. The following sections explore these options further, as well as address the impact on accounting records.
Debt and Equity Blended
Having a blend of debt and equity has several investors. Primarily, the equity portion is used to fund the growth and operations of the startup, while the debt portion provides the necessary capital to sustain it and increase return. Debt instruments can be structured in a variety of ways and can provide different levels of risk and return depending on the particulars. This type of complex structure allows startups to leverage both debt and equity in a tailored and effective manner.
The range of debt and equity options available also enables startups to quickly allocate resources as circumstances dictate. This agility allows a startup to create a tailored financial structure to suit its particular goals and aims. For example, debt and equity blended structures can leverage certain investments while minimizing the risk of others, allowing for the development of sustainable business models and the potential to take advantage of market trends.
Impact on Accounting Records
Financial structures that involve a combination of debt and equity have a direct influence on the accounting records of a startup. Accounting entries will reflect both the value of the equity and the debt, as well as the associated costs of each instrument. This can further complicate the accounting in complex structured deals, as the accounts must be structured to reflect the full complexity of the relationship.
To make matters even more complicated, debt and equity instruments both have different accounting timelines. Equity tends to be accounted for over the life of the startup, while debt instruments are often repaid shortly after they are issued. Startups will need to consider the distinct accounting approaches associated with each type of instrument to ensure that the accounts are correct and up to date.
Conclusion
When it comes to finance and budgeting for a startup, it is essential to take into account both equity and debt financing. Equity financing allows a business to maintain its ownership without incurring a loan from a lender. On the other hand, debt financing allows businesses to secure a loan while incurring interest payments.
In order to utilize the most appropriate financing structure to the benefit of your business, it is important to consider the size and short-term nature of the venture, the projected availability of cash, the impact of interest and bank fees, the long-term viability of the project, and any other potential risks. Ultimately, the right financing structure should be based on current business strategies and long-term goals.
Summary of Equity and Debt Financing
Equity financing involves selling parts of the ownership of the business to investors, who invest in the venture in exchange for a share of the profits. On the other hand, debt financing allows businesses to secure a loan from a lender, who will expect repayment with interest.
Guidelines to Utilize Financing Structures Wisely
- Consider the size and short-term nature of the venture
- Project the availability of cash
- Calculate the impact of interest and bank fees
- Evaluate the long-term viability of the project
- Analyze any other potential risks
- Match the financing structure to the current business strategies and long-term goals