Raising Capital for Startups:
Equity, Venture Debt, or Convertible Notes?
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When it comes to raising capital for startups, founders have more sources of outside financing now than ever before. While entrepreneurs often fall under the “VC spell” of Shark Tank and unicorns, there is a seemingly endless array of other financing options that may be better suited to your company’s stage and growth plans. In this article, we will walk you through the details of equity financing, venture debt, and convertible notes.
What is it?
Equity financing is most commonly used in growth companies where cash flow is difficult to predict. In an equity investment, the company raises capital by selling a percentage of their company (equity). The investor will rely on making their money back, plus an upside, in a future liquidity event (acquisition or IPO) or through distributions of future profits. Since investors become partial owners of the company, this also comes with voting rights that govern key decisions of the company.
How is it structured?
A Series A investor generally looks for 25-35% equity in the company and usually seek equity in the form of preferred stock, as opposed to common stock. Preferred stocks typically include liquidation preference, a preferred dividend, and approval rights over certain company decisions.
Pros of Equity Financing
No Cash Repayment: Unlike debt financing, equity investors are not repaid in cash by the company. Instead, investors put money into the company in hopes of the company being acquired or going public.
Access to Industry Expertise: Equity investors are involved in key company decisions, which may be useful if the management team requires an extra boost of industry expertise.
Cons of Equity Financing
Most Complex to Structure: Equity financing comes with the highest legal bills and the longest time to close, due to the complex nature of the transaction.
Most Expensive Form of Capital: Because the returns for investors are valued in equity, equity financing is the most expensive form of capital, especially if the company becomes very successful.
Loss of Control: Offering equity investors ownership of the company also requires providing them board rights, which gives some level of board control.
What is it?
Venture debt is a loan with a set schedule for repayment of principal and interest for companies with proven track records and assets to help secure the loan. In contrast to equity financing, debt lenders do not have ownership interest and do not have voting rights. Instead, these are typically senior secured loans that sit at the top of the liquidation preference pile, meaning debt lenders are paid in full before equity holders. When it comes to the complexity of documentation and legal work, venture debt is much simpler and less expensive to structure compared to an equity deal. Terms can generally last up to 3 years.
Pros of Venture Debt
Minimal Equity Dilution: Venture debt allows companies to raise growth capital without giving up large portions of equity. Potential dilution may come in the form of warrants.
Maintain Control: Since venture debt does not involve large equity stakes, founders can maintain control of business operations.
Enhanced Liquidity: A venture debt loan can help strengthen balance sheets and enhance a company’s liquidity. Businesses will achieve a more balanced and less costly capital structure when used as a replacement or complement to equity financing.
Avoid Valuation: Venture debt lenders do not require company valuations to provide capital. This allows companies to fund their growth initiatives and increase their valuations for a subsequent equity round.
Faster & Less Expensive Process: Venture debt loans are much simpler from a legal and due diligence perspective, making them much cheaper and faster to close.
Cons of Venture Debt
Cash Repayments: Interest payments are required under a fixed schedule, so the company using venture debt must be sure it can afford these regular payments.
What is it?
Convertible notes are originally structured as debt investments but have provisions to allow the principal and accrued interest to convert into an equity investment at a later date. This enables the investment to get done more quickly with lower legal fees for the company at the time while giving investors the economic exposure of an equity investment. Terms can range between 6 and 24 months.
How is it structured?
Interest: The invested funds earn a rate of interest. Unlike venture debt, these are not paid in cash, but accrued, which means the value owed to the investor builds up over time.
Maturity Date: Convertible notes carry a maturity date when the note is due and payable to the investor if they have not already been converted to equity.
Conversion Provisions: The primary purpose of a convertible note is to convert it into equity at a future time. This typically occurs under qualified financing, when a subsequent equity investment exceeds a certain threshold. At that time, the original principal and accrued interest convert into shares of whatever new equity was just sold. In addition to the accrued interest which buys them more shares than they would if they had waited and invested the same amount of money, investors often get additional perks in exchange for investing earlier. In cases where qualified financing does not occur before the maturity date, some convertible notes include provisions that automatically convert to equity at a set valuation on the maturity date.
Conversion Discount: When the convertible note converts to equity in the event of qualified financing, noteholders get credit for their principal and accrued interest to determine the number of shares they receive and a discount to the price per share of the new equity. For example, a discount of 20% and new equity is sold at $2/share, the convertible note’s principal and accrued interest converts at a share price of $1.60/share.
Valuation Cap: Convertible notes also typically have a valuation cap – a hard cap on the conversion price for noteholders regardless of the price per share on the next round of equity financing.
Pros of Convertible Notes
Quicker & Less Expensive Than Completing a Round of Equity Financing: Convertible notes are generally less expensive from a legal perspective and rounds can be closed more quickly. The company and investors are putting off some of the trickier details to a later date (certificates of incorporation, operating agreements, shareholder agreements, voting agreements, various other items).
Delay Valuation: Delaying a valuation is attractive to seed-stage companies that have not had time to show much product or revenue traction. By giving investors a discount on the price that is set later, the company is able to push that decision to a later date.
No Cash Payments Each Month: Interest payments are accrued and are either paid in cash at the maturity date or converted into equity.
Cons of Convertible Notes
If the Company Can’t or Chooses Not to Raise Equity: The company will need to make sure they have the funds to repay the note at maturity if it does not convert. Otherwise, the company may be forced to liquidate. The best way to avoid this is for the investor and company to have a clear plan for success and failure.
Valuation Caps and Automatic Conversion Price May Act as Price Anchors in Negotiations of the Next Round: Since the majority of convertible notes include a valuation cap and automatic conversion price, this effectively acts as an anchor for price negotiations of the next round.
Limited Time Frame: There is a limited time frame until the loan needs to be repaid or converted to equity.
If you are a seed-stage company looking to use convertible notes, be sure to understand all the implications of the various potential outcomes. Make sure you know what happens if you don’t end up raising additional equity and what happens if you can raise additional equity far above the valuation cap.