Determining how to raise capital for your startup or small business is an important decision. Besides just determining the amount of money you need to raise, there are several other factors that should be considered to determine what type of funding is best for your company. We will explore these options in our Fundraising 101 series. This first installment will cover the basic types of fundraising choice at a high level.
Types of Funding
In the early stages, most companies can get by with the help of the founder’s funds, but that only goes so far. The next move is generally called the “friends and family round” to gather financial support from some of your closest allies. After the friends and family stage, usually, there comes a time for most scaling startup companies to need bigger and more serious fundraising. So, how should a company structure its investments to attract such investors? Debt, convertible debt, equity, crowdfunding – these are all different options for a founder to consider.
The most common type of debt is a loan with a set amount of principal and interest payments. The investor gets their return when the company makes payments on the loan. Since uncertainty with startups tends to be high, debt investments can be hard to come by. Many banks tend to avoid offering Small Business Loans to startups, and instead loan smaller amounts and can have higher interest rates. Other investors tend to not prefer debt investments since there are no voting rights or ownership in the company. However, upon liquidation, debt holders are paid in full before equity owners. Debt investment deals also tend to be cheaper and easier to structure compared to other investment instruments since they are less complex, resulting in faster turnaround time for funding.
An equity investment is when the company sells a portion of its ownership; usually called capital or equity. Unlike a loan, there is no set timetable for when an investor is to be repaid. Many investors want to see their ownership investment appreciate with the development of the company and sell back their shares after future fundraising deals, through an Initial Public Offering (IPO) or through distributions of company profits. There are endless different classes of equity investments, such as common shares and preferred shares, that each has different sets of rules and rights based on the class of equity per the ownership agreement. Usually, equity holders have voting rights as an owner of the company. There is more risk of loss with equity investments since there is no guarantee on the return of the funds. Because ownership agreements and valuations can be extremely complex, the legal fees tend to be expensive and take a longer amount of time to complete.
Convertible notes are a hybrid between debt and equity. Initially, the investment is treated as a debt instrument and at a specific time, the note along with the accrued interest is converted into equity ownership. Convertible notes are becoming a very popular investment vehicle because they are generally quicker and easier to execute since they do not require a valuation of the company until the debt is converted. Investors also benefit due to the promise of their initial investment and interest to be converted to equity. The date of conversion is usually set by a time frame, when an event occurs or when a specific value is met.
A SAFE agreement can be thought of like a hybrid convertible debt and equity instrument. They are used to reduce the time and cost of early fundraising. SAFE stands for A Simple Agreement for Future Equity and is similar to a convertible note in that it is in exchange of funds for a future shares of the company when a triggering event occurs. Unlike convertible notes, there is no interest accruing and there is no maturity date. The investor in the case of a SAFE is taking on a higher amount of risk when or if the triggering event will occur and their SAFE will convert to equity. Due to the simplicity of SAFEs, the legal documents can be much easier to obtain.
Most third-party investors must be considered an accredited investor in order to purchase interests in private organizations. These investors usually have to have an overall net worth over $1 million or proof of steady annual incomes exceeding $200,000. However, in 2012 the JOBS Act allowed private companies to connect with investors who do not meet the accredited qualifications. There are several websites companies can use to raise funds online through thousands of individual users, called crowdfunding. Equity crowdfunding usually requires the publishing of reviewed or audited financial statements by a CPA firm. Some experts believe that equity crowdfunding can dilute company ownership without gaining the expertise of experienced industry investors. There are also different types of crowdfunding outside equity such as rewards-based crowdfunding and debt-based crowdfunding.
There are several different options when it comes to raising money for your business, including those listed above. The Anders Startup Group can help you fine-tune your financial forecasts to determine the right amount your company should raise and strategize for the tax consequences to you and your investors. Contact an Anders advisor with questions on raising funds for your startup business and stay tuned for our next Fundraising 101 series where we will take a deeper dive into Convertible Notes.All Insights