Debt vs. Equity Financing: What Your Business Should Know

At a glance:

• The main takeaway: The choice between debt and equity financing can present a variety of tax consequences, making the decision between raising funds via debt or equity an important decision.
• Impact on your business: The variety of financial instruments available to businesses and the increase in non-traditional lending and investment contracts has created arrangements that may contain characteristics of both debt and equity financing.
• Next steps: Aprio’s Tax advisors can guide you through the complexities of debt, equity, and hybrid financing to determine the best option for your business.

Schedule a consultation

Full story

Growing a business venture presents many challenges. One of the most common is obtaining outside investments to finance that growth. For businesses to obtain funding, there are two predominate methods they can use — debt financing or equity funding. Over the past few years, there has been an increase in the use of non-traditional lending and investment contracts. These arrangements don’t neatly fit into the traditional definition of debt or equity for federal income tax purposes and may contain characteristics of both debt and equity. The challenge many businesses face is how to treat these hybrid arrangements for both financial statement purposes and Federal Income Tax purposes.

One example of a hybrid arrangement that has grown in popularity is a Simple Agreement for Future Equity, more commonly referred to as SAFE agreement. With difficult-to-classify instruments such as SAFE agreements, it is important to know why the proper classification matters.

Understanding the proper classification of a debt vs equity financial instrument

Since the rise of non-traditional financing agreements and the differences between the tax treatment of debt and equity instruments, classification of debt or equity is not always clear. From a tax perspective, there are four key differences between debt and equity financing that are important for businesses to understand.

1. Expense Deduction: One of the main advantages of debt financing is that companies can generally deduct interest paid on debt as a business expense. This means that the interest paid on loans or bonds can be deducted from the company’s taxable income, reducing the overall tax liability. Interest expense may be subject to limitations under IRC §163(j). Compare that to the tax treatment of dividends, which occur as a result of an equity investment and are not tax-deductible. This makes equity financing potentially more expensive than debt financing when considering tax implications.
2. Treatment of Profits: With debt, companies are obligated to make fixed payments to debt holders, but these are considered pre-tax expenses. Compare that to an equity investment, where distributions to shareholders are dependent upon company profits and the availability of cash, which would not impact operations.
3. Risk: Debt financing involves fixed payments and a legal obligation to repay the debt. Debt results in a consistent cash outflow requirement, regardless of profitability. With equity financing, equity holders are entitled to a share of profits and voting rights. However, unlike debt, dividend payments are not obligatory. Companies can choose when to pay dividends and how much to pay, depending on the company’s financial condition.
4. Control: Debt does not dilute the ownership of existing owners of a company because creditors generally do not obtain an ownership stake in the company. With equity financing, issuing new shares dilutes the ownership stakes of the existing shareholders, as new shareholders obtain a portion of the company’s equity.

Why is it difficult to classify a SAFE agreement as either a debt or equity?

As with any contractual arrangement, how the arrangement is treated for federal income tax purposes depends upon the specific terms of the specific agreement in question. For hybrid and SAFE agreements, that is also very much the case.

A SAFE agreement is a contractual agreement between a company (generally a startup company) and an investor(s). Under the terms of a SAFE agreement, an investor pays money to a company in exchange for certain contractual rights granted to the investor in the SAFE. The most important rights that the investor generally receives, is the right to future equity in the company after a triggering event specified in the SAFE agreement.

When trying to determine whether the hybrid or SAFE agreement in question is debt or equity, there are some key provisions in the agreement which should be reviewed as part of that analysis. The first among these is the default/bankruptcy sections, which highlight the investor’s rights should the underlying business, and therefore the agreement go bad. In those situations, does the investor “stand in line” with the other debtor or do they stand in line with the owners of the business when it comes time to get some of their investment back?

The other key provision, is the part of the contract which provides for what the investor receives at the trigger event, when things go well for the operations. At that point, does the investor receive stock, and if so what kind of stock? Is the company at that point required to authorize a new class of stock or issue stock from an existing class? Was the company required to authorize the new class of stock at the point when the agreement was signed or when they received the cash from the investor? Did a third-party hold stock shares that weren’t authorized and issued until the trigger event occurred? All these factors should be considered when determining the classification of the agreement as debt or equity.

The Internal Revenue Code (IRC) does not address the proper classification of a hybrid or SAFE agreement into either debt or equity, so a facts and circumstances approach similar to what is discussed above must be taken. In their own terms, SAFE contracts are generally not equity at issuance but instead, a right to purchase equity in the future. Under a standard SAFE agreement, the investor is afforded liquidation rights if the company dissolves, a characteristic that is more typical of a debt instrument than equity. However, standard SAFE agreement terms lack an interest-bearing component or a maturity date, both of which are key components of a debt instrument. Each SAFE agreement must be analyzed on its own specific terms before deciding how to record a non-traditional financing agreement.

Lastly, while the hybrid or SAFE agreement may not be debt or equity, it may just be a general liability until either the trigger event or the dissolution event occurs, depending upon the terms of the specific agreement.

The bottom line

The choice between debt and equity financing can present a variety of tax consequences alongside other financial, operational, and strategic factors. Debt financing offers a tax advantage through interest deductibility, reducing taxable income, and lowering the overall tax liability. However, it also comes with the risk of mandatory interest payments and potential limitations on deductions. Whereas equity financing avoids mandatory payment and interest deductibility limits but does not provide a tax benefit.

The variety of financial instruments available to business owners and investors do not always resemble a clear debt or an equity investment, which can lead to uncertain tax treatment. Hybrid agreements such as SAFEs are gaining popularity due to their simple terms and execution for business owners and investors. However simple the terms may be from an investment perspective; the tax treatment is not always so. This may require a thorough review of the provisions of the agreement before the determination is made. Aprio’s Tax professionals can guide your business through the process.

Schedule a consultation today.