At some point during your ventures life cycle, you will need to decide upon whether or not to incorporate your business (into a corporation). The type and or form of equity that your business will need are dependent upon, the legal business structure of your enterprise. As a sole-proprietor, your investment into your business is just recorded as an owner’s personal investment. As the owner, your equity, is really just in fact the money invested into the business. If partners are involved in your business, you must have some agreement stipulating the “terms and conditions of each equity investors contribution”. [1] Both parties will then need to sign a shareholders agreement, in which covers such details as: What happens if one of the partners were to die? Which partner is investing what? How will investments be paid back, and under what circumstances? What happens if the business fails? To get the most accurate coverage of a shareholders agreement it’s recommended that both parties seek individual advice i.e. legal. If it’s decided that the business will be incorporated, it would be recommended to use a lawyer to draft the shareholders agreement, to outline the roles and responsibilities of each equity investor.
For small businesses there are three significant forms of equity financing, these include: Common shares; preferred shares; and convertible debentures.
Common Shares: These shares are equity investments that give part ownership of a firm, but not as safe as preferred shares are, should the business fail. They are issued in exchange for a firm’s initial capital. As an organization values increases, the shares overtime will improve in value, and provide income in the form of dividends to those shareholding parties. If the company’s value were to decrease then the common shareholders risk losing their investment in its entirety. Some provinces within Canada, will provide up to 25-30 percent of a shareholders investment that was lost, this is to encourage people to place capital in small businesses.
Preferred Shares: These are also equity investments which grant part ownership of a particular company, as well generates investors dividends at a fixed rate. These shares are much safer to invest in then common shares. In the event of the business failing, the investors are better protected than if they were too invest in common shares. Unlike debts, preferred shares have no maturity date; as well dividends that are paid out are not as binding as interest payments on debt incurred.
Convertible Debentures: These are loans that can be traded in for common shares in a firm at pre-established price. Like most debentures and bonds, these carry a fixed interest rate, and re-payment date. These shareholders have the opportunity to benefit if the company’s value were to increase. Because the debentures are a type of loan, its interest is tax deductible. On a final note, these convertible debentures are better protected than those shareholders of both common and preferred shares, in the case of the business going under.
[1] Knowles, Ron. (2004). Small Business: An Entrepreneurs Plan. 3rd Edition. Thomson & Nelson. (pg. 213)