I currently work in a business that manufactures detergent. It is a very profitable sector. I wish to retire after three years and establish my manufacturing plant. I want to know more about the options I have on raising capital and the legal implications of each. –Kamau
Dear Kamau, I will respond to your inquiry through a series of articles on start-up funding . Today I provide an overview and will break this down into a series of articles. Kamau, the first obvious source is personal investment or savings. Many start-ups are self-financed, meaning that the founder of the business raised capital from personal sources.
It is the simplest source of finance and in my view has little or no legal implications. This makes it the easiest and fastest way to raise capital.
However, the downside is that you can only raise limited amounts of money and there is more risk exposure. If your business does not make any profit, then you will have lost savings.
The second source of capital is what is commonly known as “love or patient capital.” As the name suggests it is capital raised from “loved ones.” Borrowings from your spouse, friends, and family are classified as love capital.
It is somewhat easy to raise compared to other formal sources of capital. It largely depends on the extent of your relationship with loved ones, and their willingness and capacity to lend to you.
The downside is that it may strain close relationships if the loan terms are breached. Many friendships break based on unpaid soft loans. Love capital may be conditional or unconditional. Some lenders may insist on a loan agreement which I will break down later.
The third source of capital is debt capital. This is the type of borrowing that is more formal and from a financial institution. Please dig deeper when borrowing from a financial institution. Get to understand the different loans available and the terms of the loan and settle for the most suitable.
Most lenders will subject you to a rigorous vetting process before disbursing the funds. Some require collateral security or guarantees to further secure the loan. The loan is secured by a loan agreement or in some cases mortgages and other securities.
It is important to see a lawyer to review all legal documentation for you and help you understand the terms of lending.
The major covenants in a loan agreement are an agreement to pay back the borrowed amount together with interest on specific dates. If you default, then the agreement contains what would happen in the event of default.
You may be subjected to penalty interest; your security may be sold off or your business wound up! The advantage of debt is that you can raise more than the previous methods.
Fourth is equity capital which is raised from private investors. An investor can give you the funds you need in exchange for a percentage of ownership. As the investor comes in as a co-owner of the business then there are various legal documents to be signed.
The shareholders’ agreement governs the relationship, decision making, rights and revenue sharing between you and the investor. Some investors are in for the long haul while others only want to make a profit and exit.
Your lawyer will advise on the right documentation and structure to use under this model.
In my next few columns, I will continue to demystify start-up funding and the law to help you make a decision.
Ms Mputhia is the founder of C Mputhia Advocates.