Startup financing options – equity vs debt vs convertibles

Startup financing options – equity vs debt vs convertibles

Entrepreneurs are not always aware of the various financing structures that may be available to them when raising new capital to finance their growth. Even if they are, they are not always sure what fair terms look like when receiving term sheets from investors.  

This article explores the plusses and minuses of equity vs. convertible debt vs. venture debt. Please note that there are many subtleties to each of the securities discussed below and this does not address all of them, but is meant to give a very broad overview.  

Equity

Issuing stock in your company is the route most entrepreneurs pursue, especially for growth companies where cash flow is difficult to predict, hence making it tough to forecast repaying debts. Equity is typically secured from angel investors or venture capital firms.

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Representative Terms:  A typical Series A (first institutional round) investor is looking for 25 percent to 35 percent of the company, in exchange for its investment. So, if you are worth $1MM pre-money, an investor would likely give you $500K for a 33 percent stake, as an example.  

Most professional investors will be seeking equity in the form of preferred stock, not common stock, where they get a six to eight percent interest and a liquidation preference of one times their money back before the common shareholders begin to participate in any sale proceeds for the business.  

There are number of types of preferred – including participating preferred, where investors “double dip” on their interest and liquidation preference and also get their equity upside pro rata. However, if this structure is used there is frequently a limit of two to four times the liquidation preference before the participating feature goes away.  

The other type of preferred is straight convertible preferred where an investor will get their six to eight percent interest plus money back or they can convert and get the equity upside of their stock pro rata with common. The security will include some form of anti-dilution protection for the investor, typically a weighted-average rachet in the event of a subsequent financing at a lower valuation.  

equity

The investor will also be looking for protective provisions, in terms of their rights as a shareholder to block certain major actions (e.g. change of control, modification of the board size, changing the charter so as to adversely affect their security, etc).  

Typically all employees will be required to enter into invention assignment, non-disclosure, non-solicitation and non-compete agreements. In addition, an investor may ask the founder to vest some portion of their shares, in case they need to make an executive change or if the founder quits. As an example, a founder may be asked to vest 50 percent of their ownership over a two to three year period, a pro rata portion “earned” each month.

Advantages:  Does not have to be repaid, like debt does. Gives certainty of valuation for your company which can also be a disadvantage if the value is very low.

Disadvantages:  The most complex to structure (highest legal bills, longest time to close). Usually involves giving some level of board control to investors.

Convertible Debt 

For situations where you do not want to set an equity valuation (to not impede subsequent financings from other investors), or you simply want the option of potentially paying back the cash, for a period of time prior to taking in permanent equity capital, a convertible note is the way to go.  

A graph showing the German DAX index is

A convertible note is a hybrid, part debt and part equity, where it functions as debt, until some point in the future, when it may convert to equity at some predefined terms. Convertible debt is typically secured from the same angel investors and venture capitalists that fund equity deals and is usually used for smaller rounds of financing at the early stages of a company’s life.

Representative Terms:  A convertible note typical carries an interest rate of four to eight percent per year, which is usually paid “in kind” (grow the principal each month, not paid as cash interest).  The note will typically convert into equity in the company’s next financing, typically at a 15 to 20 percent discount to the valuation realized in a subsequent round or with warrant coverage of 15 to 20 percent. The discount can be as low as zero percent and as high as 50 percent, depending on the situation.  

The conversion valuation of the company is not fixed, however, investors often will negotiate a cap on the highest valuation their loan may be converted at regardless of the price on the next round.  Being uncapped is the best position for the entrepreneur, but cannot always be achieved in the negotiation. The term of the convertible note can be as short as six months or as long as two years, depending on the needs of the company or the investor.  

investors

If no following investment round is achieved during the term, the note can either auto-convert into equity at some preset terms, or be required to be repaid in cash at such time. The latter potentially being a gun to your head that could force you to sell the business at a distressed price to repay the loan. So, shoot for the former, where you can.

Advantages:  Much quicker and cheaper than issuing equity, both for legal bills (can close in weeks, not months) and ownership dilution (deferred until down the road and you can use the note proceeds to increase the value of your company). It leaves valuation flexible in order to meet the needs of subsequent investors. Interest payments do not typically need to be paid in cash each month.

Disadvantages:  You have a limited time frame before it needs to be repaid, or convert into equity.

Venture Debt 

For startups with an existing product/track record or existing or future assets to secure a loan, venture debt is another option to consider. Venture debt is a senior secured loan that sits on top of the pile, in terms of liquidation preference (repaid before all other debt or equity holders). Venture debt is typically issued by more aggressive bank lenders, like Silicon Valley Bank and Square One.

(FILES) - A picture taken on December 15

Representative Terms:  The note will most likely be secured by 100 percent of the assets of the business, and the lender will typically lend 25-75 percent of the fair market value of assets, depending on the nature of the assets (e.g., ease of liquidating) and the stability of your business (e.g., consistent performance over last couple quarters).  

The lender will also most likely require that cash collateral be posted or the executives to personally guarantee the loan, in the event the company cannot repay it.  The note typically comes with a 6 to 18 month term, and carries a monthly cash-paid interest rate in the range of prime plus two-four percent per year.  There are often, but not always, warrants issued to the lender in these types of transactions.

Advantages The least dilutive to your ownership, allowing you to keep 100 percent control and economic upside.

Disadvantages:  Do not take this on if you do not have 100 percent visibility into repaying the loan, as the bank can force you to liquidate the company to recoup their loan, forcing the company (or yourself as guarantor) into liquidation or bankruptcy. Interest payments need to be paid in cash each month.

Be sure to read my other articles on this topic, which have more details to consider: How to Raise Capital for Your Startup, How to Value Your Startup, and Frequent Legal Questions of a Startup.

There are many “variations to a theme” as it relates to investment structures and the above just touches on the big themes, so be sure to solicit the advice of a lawyer who knows these deals well.

Read Next: Can’t attract VC money? Buy a business with private equity

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