July 7, 2020

How to Turn A Great Idea into a Startup Business

As an entrepreneur, when you have a great idea, it can be exciting to get a new business started right away. But to make sure the startup is set up for success, there are necessary steps entrepreneurs need to take. Proper planning up front by creating a business plan, building a great team and developing a financing strategy will help turn a great idea into a profitable business.

Create a Business Plan

The first step is to create your own business plan. The business plan could originally be for yourself to help you build out your strategy on paper. The business plan could also be for external investors or other business partners down the road. Deciding who you are making the business plan for is a key step.

The final business plan that you create should contain your business’s key goals and how you plan on achieving those goals. Key areas of your business plan should include:

  1. Business Description
  2. Company Analysis
  3. Industry Analysis
  4. Marketing Plan
  5. Plan for Operations
  6. Financial Plan

Your business plan should come together as a quality, professional document. This plan will likely be referenced by outside parties and is key in helping you achieve your goals. The plan can and should evolve as you are working your way through developing your business.

Build a Team of Advisors

The next important step is building a team that can help advise you. Having a CPA and an attorney that are the right fit for you and your business can go a long way. Make sure your business culture meshes with their culture and values and that you can trust them. Both your attorney and CPA will be there to answers your questions, so knowing that they have your best interests in mind and that you are able to count on their advice is important.

An attorney can help draft up agreements, copyrights, patents, or other legal documents that might be needed, and a CPA can help you choose the proper business entity type that will best suit your needs as well as helping with accounting and bookkeeping throughout operations. As your business grows and becomes more complex, so does the accounting as well as potential legal issues. Make sure your CPA and attorney are have your goals in mind.

Next Steps and Financing

Once you have your plan and your team in place, there are now decisions and steps to take that both your attorney and CPA can help with.

  1. Select your business entity. Whether you form your business as a Sole proprietor, S-Corp, C-Corp, LLC or Partnership, each entity type has different tax and legal factors, so choosing the one that best suits your business is important.
  2. Register your business with your state.
  3. Request and obtain Federal and State identification numbers.
  4. Open a separate business bank account.
  5. Choose an accounting and recordkeeping software.
  6. Depending on your industry, consider purchasing general liability insurance.

A final step before being able to operate your business is obtaining proper financing for the operations.

Equity Financing

Equity financing means exchanging part of your ownership for cash. The positive of this option of financing is there are no interest payments that need to be made. This can be a very beneficial way to preserve cash when initially trying to get up and running. The downside is the loss of ownership which results in less earnings being distributed to yourself.

Debt Financing

A debt financing structure means borrowing money that will be repaid with interest. The positive of this way of financing is there is no lost equity in your business as well as the interest and principal payments are consistent and can be planned for. The downside is the interest that is to be paid as every bit of cash can be important when starting a business.

Owner Financing

Financing the business on your own is the most lucrative since there is no equity lost and no interest to be paid. However, many entrepreneurs will not be able to sustain the cash flow required to keep the business going, and will eventually require funding from debt or equity financing.

You have your plan, you have your team in place, and you have financed your business. You are now ready to begin operations and turn your dream idea into a reality. Throughout operations, continue to consult with your CPA and attorney as they can provide valuable advice every step of the way. Contact an Anders advisor to discuss your new business, or learn more about the Anders Startup Group.

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June 23, 2020

Paying Too Much in Taxes? Here are Common Expense Deductions Startups Miss

Many profitable companies, including startups, are paying more in taxes than they should solely because they are not accounting for all expenses that they are legally allowed to deduct, including home office, internet, cell phone and car expenses. Understanding how to properly record and categorize expenses, and differentiate between business and personal expenses is key to minimizing tax liability.

Record Expenses When They Occur

Keeping track of what your business spends money on is hard enough, so do not wait until the end of each month or even the end of the year to try and go back and remember what you spent and when. In the end, you will probably end up forgetting about many expenses that were incurred.

If you are unable to record the expenses right away, at a minimum, you should at least save the receipts so they can be used to help you go back and record your transactions. With online banking making it easier to access transactions, many times we can see where we purchased something, but we need the underlying receipt to give us more details on the transactions. Additionally, under audit, the IRS will ask for receipts to support the expenses you are taking. Then at the end of each month, make sure you reconcile your cash account to your bank statement to make sure there are not any discrepancies.

Categorize Expenses

Being able to categorize expenses into categories can save you time and money in the long run. If you give all the receipts that your company had over the year, and ask your CPA to prepare your taxes, it is going to take them a lot longer than if you had them categorized. Once all the expenses are sorted into different categories your CPA will review and determine if all the expenses are deductible. One thing to note: if there are expenses that you are not sure how to categorize, most accounting systems have an “Ask your accountant” account which could be used as a placeholder until you can discuss those transactions in more detail with your advisor.

Know What Expenses Can be Taken

Having an understanding as to what expenses you can take in your business is also very important. Almost all expenses that occur in a business for it to function can be used as an expense, but your CPA can determine whether these expenses are fully, partially, or completely non-deductible under current tax law. Many people understand the basic ideas of what can and what cannot be taken against their company’s income, such as advertising, employee wages and compensation, rent, repairs, legal services, supplies, taxes and more, but there are many other expenses that are overlooked each year. A few of these expenses are listed below.

Home Office

There are a few different ways to calculate your home office deduction using the simplified or regular method, but under each method there are a few things you do need to make sure you have documented in order to take a deduction:

  1. You must regularly use part of your home exclusively for conducting business and not for personal use.
  2. This area in your home must also be considered your “regular” place of business. What this means, is that you cannot have another office/workspace that you could go to in order to perform your work. If you do have a space at the office, that automatically excludes you from this deduction.

Internet/WIFI

If you have internet or WIFI in your office building, you can write off this expense. In addition, if you use your home internet for your business and for personal use, you can potentially take the percentage of internet used for business as an expense, but you do need to determine how much of that expense relates to personal use.

Cell Phones

The same rules that apply to your internet/WIFI, also apply to cell phones. If it is used exclusively for business, then all expenses can be deducted. If it is only used partially for business and the rest for personal, the percentage that is used for business purposes can be taken as an expense.

Car/Auto Expenses

Any vehicles used/purchased for business can also be deducted against your income. Similar to the home office deduction, there are two methods in order to take a vehicle deduction: the mileage and actual methods. Your CPA can review and evaluate which deduction will be best for you given your individual situation, but in order for them to determine that, you should keep track of the following information:

  1. Fuel cost
  2. Business miles driven
  3. Personal miles driven
  4. License fees
  5. Insurance
  6. Repairs
  7. Anything else that is used to keep the vehicle running for your business

Travel

When traveling for business, it is important to keep track of all expenses that you have. A wide variety of expenses during travel are deductible to a business, anywhere from how you got there, such as bus, flight or train, to what you ate, to what means of transportation you used while you were there could all potentially be deductible on the business level.

As we discussed, the key to deducting expenses is to make sure you are keeping receipts and recording transactions in a timely manner, so you do not miss anything. You want to make sure you over document and ask questions if there are any expenses you are not sure about. If you have any questions about if something qualifies as a deductible business expense, contact an Anders advisor

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June 9, 2020

Accounting 101: Deferred Revenue and Expenses

Under the accrual basis of accounting, recording deferred revenues and expenses can help match income and expenses to when they are earned or incurred. This helps business owners more accurately evaluate the income statement and understand the profitability of an accounting period.

Defining Deferred Revenue and Deferred Expenses

Deferred revenue is money received in advance for products or services that are going to be performed in the future. Rent payments received in advance or annual subscription payments received at the beginning of the year are common examples of deferred revenue.

Deferred expenses, also called prepaid expenses or accrued expenses, refer to expenses that have been paid but not yet incurred by the business. Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance.

Accounting for Deferred Revenue

Since deferred revenues are not considered revenue until they are earned, they are not reported on the income statement.  Instead they are reported on the balance sheet as a liability. As the income is earned, the liability is decreased and recognized as income.

Here is an example for a $1,000 payment for services that have not yet been performed:  In this transaction, the Cash (Asset account) and the Unearned Revenue (Liability account) are increasing.

DebitCredit
Cash$1,000 
Unearned Revenue $1,000

Once the services are performed, the income can be recognized with the following entry:  This entry is decreasing the liability account and increasing revenue.

DebitCredit
Unearned Revenue$1,000 
Revenue $1,000

Why is deferred revenue considered a liability?  Because it is technically for goods or services still owed to your customers.

Accounting for Deferred Expenses

Like deferred revenues, deferred expenses are not reported on the income statement. Instead, they are recorded as an asset on the balance sheet until the expenses are incurred. As the expenses are incurred the asset is decreased and the expense is recorded on the income statement.

Below is an example of a journal entry for three months of rent, paid in advance. In this transaction, the Prepaid Rent (Asset account) is increasing, and Cash (Asset account) is decreasing.

DebitCredit
Prepaid Rent$750 
Cash $750

Once one month of the expense has been incurred, the expense can be recognized with the following entry:  Here we are decreasing our Prepaid Rent and increasing our Rent Expense on the income statement.

DebitCredit
Rent Expense$250 
Prepaid Rent $250

Under the cash basis of accounting, deferred revenue and expenses are not recorded because income and expenses are recorded as the cash comes in or goes out.  This makes the accounting easier, but isn’t so great for matching income and expenses. Learn more about choosing the accrual vs. cash basis method for income and expenses. If you have any questions about deferred revenue and expenses, please contact an Anders Advisor.

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May 26, 2020

Why Startups and Entrepreneurs Are Set Up to Succeed in a Post COVID-19 World

As states begin to start easing restrictions on stay at home orders, people are continuing to wonder what the new “normal” is going to look like, especially for businesses. While it is clear that every business, regardless of industry, will need to figure out what adjustments they will make going forward, there is good evidence that entrepreneurs and startup companies might be the best equipped to succeed in the post COVID-19 world.

Knowing How to Pivot

As we emerge from the COVID-19 pandemic, most, if not all, businesses are going to have to make some type of pivot. It should not be a surprise that most entrepreneurs and startups are normally the best at adapting to changing environments and opportunities since many of them face these challenges in the initial years of starting their business. In fact, many businesses have already started doing this and have had great success at it. In just the St. Louis region, we have seen startup manufacturers and developers shifting part of their production lines to help mitigate the spread of the virus. They were able to modify their business model and start these new lines in a matter of weeks. They are proving as changes continue to evolve, there is good opportunity that many of these companies will be able to adapt and pivot to these changes.

Leading the Way in Virtual

As people are still hesitant to leave their houses, businesses need to think about having more options in order to run a virtual business. Not only for the safety of their customers, but also for the safety of their employees.  While this may not be the easiest change for many businesses, if they can make this change, they will see great success in their businesses model. Within the startup and entrepreneur enterprise, these virtual businesses were already starting to be created, but with the pandemic, we have seen them expand significantly. Even the organizations that support entrepreneurs have quickly moved to create new ways in order to connect virtually. We have already seen these changes being made by organizations like Venture Café, which has changed their weekly networking meetings into virtual networking meetings. While this may be a different way to connect people, Venture Café has made this pivot in order to meet their goals of the organization and they have made this change successfully.

Creative Fundraising

During the pandemic, there has been a significant decrease in investments into startup businesses as people are understandably becoming more conservative with their money. Not only that, but for those investors who are still willing to invest in new companies cannot decide on what companies to invest in since the majority of businesses pitched their company to investors in person before they received fundraising. While this is a downside for many entrepreneurs, fortunately, many of the programs are finding new ways to connect with their entrepreneurs. For example, Capital Innovators still had their annual Demo Day, but this year they converted the Demo Day to an all-day virtual day where all the companies have pre-recorded their pitches which can be viewed by investors at their convenience. Invest Midwest is another example of an organization going virtual. Both of these prove that the entrepreneur support group has already been working on ways to improve processes and with more time, these programs will become even more robust.

Entrepreneurs and startup businesses have proved that we are all in this together and together we will all get through these unprecedented times. They are already proving that the companies who learn to adapt and can pivot will be the most successful companies emerging from this pandemic.

Learn more about how Anders works with startups, or contact an Anders advisor to discuss how COVID-19 is affecting your business. For additional resources, please visit our COVID-19 Resource Center.

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March 23, 2020

Saving Venture Café St. Louis: The Anders CPAs + Advisors Challenge

By bringing entrepreneurs, companies and investors together, Venture Café St. Louis has helped propel the success of our startup community. But as of last week, all in-person, public events, which are a main source of income, have been postponed due to COVID-19 health concerns. Venturé Cafe St. Louis has helped so many local startups in our community, and now it’s time to help them. With that in mind, we’re introducing the Anders CPAs + Advisors Challenge.

“Venture Café has always been a safe, welcoming space where entrepreneurs and startups can connect, share ideas and build relationships,” says Dave Finklang, founder of the Anders startup practice. “It has been the foundation for many creative ideas and conversations that have turned into profitable, growing companies in our region.”

About the Challenge

Recognizing the value Venture Café St. Louis has brought to Anders growing startup practice, we decided to help.  So we are challenging everyone who:

  • Met an investor at Venture Café
  • Invested in a startup introduced at Venture Café
  • Networked at Venture Café
  • Presented at Venture Café
  • Learned something new at Venture Café
  • Has a new contact, colleague or friend from Venture Café
  • Enjoyed the camaraderie or benefited in any way
  • Have used the Innovation Hall free workspace

Join us in helping give this Leader in Innovation the opportunity to keep innovating.  We’ll start with a $2,500 donation and hope businesses and individuals who value their contribution to St. Louis to accept our challenge and give what you can.  There are no minimums or maximums on this challenge.

Learn more about Venture Café St. Louis and donate here.

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March 17, 2020

Start Up Your Company with an Accountant

Many entrepreneurs believe not having access to creative tools, software and space are the biggest obstacles to getting a business off the ground. According to Forbes, lack of capital is the biggest reason why startups fail. Having an accountant on your team from the beginning can make the difference between success and having to start over. Below are several reasons it’s important to have an accountant on your team from the beginning.

Help Attracting Investors

When starting a business, the entrepreneur-turned-owner is typically the company’s only employee. This means running day-to-day operations, marketing, networking, and many other roles. Which leaves little time to manage the finances. An accounting firm can alleviate some of that extra burden by keeping the books and records up to date. Accurate books and records, along with timely financial statements, are key to raising capital and the success and growth of a business. As an added bonus, investors love seeing an accountant on the startup team.

More than Tax Returns

Filing your yearly tax return and making sure your company is compliant is going to be a major part of an accounting firms’ job, but there are many other areas they can help with. Payroll questions, entity planning, state and local taxes, fundraising, and valuations are all important items that deserve attention from any entrepreneur looking to start their business. With an already complex tax code along with recent tax reform it is now more important than ever to have a knowledgeable team of accountants and advisors to not only keep your company compliant, but to make sure you are taking advantage of any items that are available for your startup.

Local Resources to Help You Grow

Another benefit of partnering with an accounting firm that specializes in working with startups and entrepreneurs is tapping into their network of potential investors, business relationships, and entrepreneur resources. The St. Louis startup ecosystem is rich with hubs of activity that are available to all entrepreneurs.

Between shared workspaces, incubators, accelerator programs, competitions, venture capitalist firms and grants, there are endless opportunities for entrepreneurs to fund and grow their startup visions in St. Louis. The shared workspaces give a lower cost option to traditional office spaces, not to mention the close proximity to other like-minded individuals. Accelerators and incubators help startups by providing money or operational resources, which can sometimes even include free rent at a shared workspace! Competitions, venture capitalist events, and grants are more ways for startups to show off their ideas and companies and fund their startups. With an abundance of opportunities, St. Louis entrepreneurs have all the tools to create their dreams.

With the many resources available in St. Louis, the lack, or mismanagement, of capital shouldn’t be the reason your startup doesn’t succeed. Bring an accountant to your team and watch your company grow. Contact an Anders advisor, or learn more about the Anders Startup Group.

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December 17, 2019

Entity Planning for Startups: 6 Questions to Ask Before Classifying as a C-Corporation or LLC

While seemingly a minor decision that many startups do not invest much time or planning into, the decision to start the company as an LLC or C-Corporation has some significant tax implications, both short term and long term. Below are several key differences between these two entity types to start the planning discussion for your startup company.

1. Who benefits from the startup tax losses?

LLC

The individual owners reap the benefits of the tax losses from the company, as LLCs are referred to as “flow-through” entities. Simple in concept, but much more complicated in execution, LLCs split their losses for the year based on some percentage, either a profit/loss percentage or a special allocation percentage, between the owners. The owners then report their share of the LLC losses on their individual tax return for the year. Depending on the tax basis rules and the tax passive loss rules, the owners may be able to deduct their share of the LLC’s losses against their other income sources for there. Which, then reduces their overall tax for the year. While the tax deductions are not a dollar-for-dollar offset to the owner’s tax, they do serve some immediate economic benefit to the owner versus waiting purely for an earn-out event or dividend in the future.

C-Corp

The company itself benefits from the tax losses generated during the year. This is because C-Corporations are their own taxable entity in the eyes of the IRS, so the company is subject to tax at the entity level. If the company generates a loss, then the company does not pay any tax that year. It’s important to note that this applies to Federal tax and many states. However, some states do have minimum tax amounts that are assessed regardless of profitability.

In years in which the company generates tax losses and does not utilize them in that year, those losses generate a “Net Operating Loss.” Those losses can then be carried-forward to the next year to offset a future year’s taxable income. If there are multiple loss years in a row, the losses compound on each other year-over-year to create a larger Net Operating Loss to be utilized once the company is profitable.

2. Are the owners subject to yearly tax reporting with an ownership interest in the entity?

LLC

Due to the flow-through nature of an LLC, the owners are subject to yearly tax reporting due to their ownership interest in the LLC. This reporting is done by way of a “Schedule K1” from the LLC to the owner. The K1 is how the company reports each owner’s share of profit or loss for the year, as well as many “separately stated” income and deduction items from the company. Since the K1 is needed to file the owner’s individual tax return for the year, the owner will have to wait for the company’s tax return to be completed for the year, as the K1s are prepared with the company’s tax return for the year. In other words, the K1s are not stand-alone forms that can be prepared ahead of the company tax return like an employee’s W2 Form can.

C-Corp

Since C-Corporations are their own taxable entities, the owners are not subject to tax on the C-Corporation’s taxable income for the year, just as the owners do not benefit from the C-Corporation’s losses for the year. There is no additional tax reporting from the C-Corporation to the owner for the year, which means owners of C-Corporations do not have to wait for the C-Corporation tax return to be filed in order to file their individual tax return for the year. The only caveat would be if the C-Corporation issues dividends to the owners, or pays the owners wages for services provided to the company. If either of these applies, the C-Corporation will issue the owner a 1099-DIV for dividends or a W2 for wages. These are required to be issued by the end of January, so they do not hold up the owner’s tax return any more than any other tax forms for the year, such as bank 1099 forms, home interest 1098 forms, investment tax statements, etc.

3. Who pays the tax once the company becomes profitable?

LLC

Just as the owners benefit from the tax losses from the LLC, they are also responsible for paying the tax on the company’s taxable income for the year. Most owners are shocked to hear this, as why would they have to pay the tax on the company profit? While on the surface this seems counterintuitive it actually works to tax the company profit only one time, at the owner level. Since the owners are paying tax on the company income, most LLCs will make cash distributions to the owners to pay the tax. These are simply called tax distributions, and effectively make it that the company is using its cash to pay its tax. It just requires the tax to be reported by the owner, who is then given company cash to pay the tax.

C-Corp

Just as the company benefits from its tax losses, it also pays the tax in profitable years. As such, there is not the need to pay tax distributions to the owners because their tax returns are not impacted by company tax profit.

4. Does double taxation apply?

LLC

Aside from states that have state-level LLC tax, an LLC is not subject to double taxation the Federal level. This is the scenario in which the company pays tax on its profit, and then the owners pay tax on their cash distributions from the entity. For an LLC owner, as long as they have “tax basis” in their cash distributions, they do not pay additional tax on those distributions. Profitable LLCs only pay tax on the profit one time, which is done at the owner level.

C-Corp

C-Corporation profit, when paid out to the owners as dividends, is taxed two times. The first time is when the company pays tax on its profit for the year. Then, a second time when the owners are paid a dividend for the year because the owners are subject to tax on their dividend payments from the company. There are favorable tax rates for certain types of dividends, however, tax does apply still. As such, profitable C-Corporations that pay out dividends every year are subject to double tax.

5. What is the tax impact of selling ownership?

LLC

When selling an LLC interest, the owner’s gain on the sale is subject to tax on the gain. The gain is the total sales proceeds less the owner’s tax basis in the ownership interest. While, there are some scenarios in which some of the gain could be subject to ordinary tax rates, the hope in selling an LLC ownership interest is for capital gains tax rates to apply. If the ownership interest is held for over a year, then the favorable long-term capital gains rates would apply. This gives the LLC owner an effective tax break on selling the LLC ownership.

C-Corp

As with an LLC, when a C-Corporation ownership interest is sold, the sale is subject to tax on the gain on the sale. The gain is calculated similarly to an LLC ownership interest sale in which the proceeds less the owner’s tax basis in the ownership interest. The gain would be subject to capital gains tax rates, and would get the favorable long-term capital gains rates if the ownership is held for over a year.

6. Are there tax benefits when selling ownership?

LLC

For LLC owners, aside from long-term capital gains tax treatment if ownership is held for over a year, there are no extra tax benefits at the point of sale for LLC ownership.

C-Corp

For C-Corporation owners, there is a significant tax benefit for owning Qualified Small Business Stock, which is stock of a qualifying small business corporation. If the owner holds their stock for at least five years, they can sell the stock and avoid paying tax on the first $10,000,000 in gain on the stock. This could even be higher depending on the amount they purchased their stock for, but they would at least get to exclude the first $10,000,000. At a 30% tax rate, which is not uncommon when Federal capital gains tax, Net Investment Income Tax, and state tax apply, that would be a $3,000,000 tax savings. This can be a huge tax benefit and incentive to invest in C-Corporations that are Qualified Small Businesses.

If the Qualified Small Business Stock is sold within five years, then the tax gain exclusion is lost. However, if those proceeds are used to purchase new Qualified Small Business Stock, then the gain on the sale of the first stock is deferred until the new stock is sold. While this does not give the owner the permanent gain exclusion, it does allow the owner to “serial invest” from one Qualified Small Business into the next.

While there are some other subtle tax differences between the two entities, we highlighted the most significant tax differences between an LLC and a C-Corporation. As with any company structural decision, there is not one of the above factors that should be the sole decision point for deciding between LLC and C-Corporation for your startup company. A planning discussion around all of these factors, as well as the legal implications of each entity, should be engaged in prior to determining the legal entity type for your startup. For more information on this planning area, or for assistance in determining your entity type, please contact an Anders startup advisor.

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October 22, 2019

Cybersecurity for Startups: A 5 Step Plan for Preventing Costly Data Breaches

All startups have one thing in common when it comes to cybersecurity: they all are at some level of risk of a costly data breach. Startup business owners may not even be aware of certain vulnerabilities including ransomware, phishing, data loss or intercepted payments from clients – all potentially fatal incidents for a startup. Below we dive into five ways entrepreneurs can protect their business from cyberattacks.

Step #1: Evaluate Risk

The first step of consideration in defining a cybersecurity program is asking if risk has been evaluated. If so, how is risk addressed in the company? Having a plan around lowering cybersecurity risk can help protect startups from cyberattacks and create action items in an event of a breach. Anders Technology Services has experienced advisors to help startups identify, protect, detect, respond and recover from cybersecurity risks.

Step #2: Implement Security Practices

After assessing risk, it’s important to implement security best practices that are personalized for the business landscape. Ask the following questions to discover areas to address:

  • Are we connected to the internet both internally and externally?
  • Do we have webcams?
  • Do we have servers?
  • Do we have laptops?
  • What information could potentially be exposed?
  • Externally, mainly focusing on software as a service (SaaS), how do the software agreements address security?
  • Do we send information to other businesses? If yes, what are their security practices for protecting the information we share?

Using reputable SaaS systems can offload some of the security burden as part of a cybersecurity strategy. Some even offer discounts to startups, such as Microsoft, who gives startups $200 plus 12 months of free services to get started and test the latest products.

Step #3: Know Who to Call

If a breach or cybersecurity incident occurs, have an IT provider on deck to reach out to immediately. A quick response is vital to mitigating impact on the business. Develop a relationship and level of trust with an IT company that has a focus in cybersecurity. Calling an IT firm for the first time when an event occurs only adds unnecessary time wrapped up in information gathering.

Step #4: Develop a Recovery Plan

How will the critical functions of the business continue to operate if a cybersecurity incident restricts production or productivity? Developing a disaster recovery plan will help determine what workarounds are available and how long the business can survive without production components in place.

Step #5: Learn from Other Startups

Look into what others in the startup community are doing about cybersecurity. Have they experienced an incident? What do they do to prevent incidents in the future? Being part of a startup organization or an incubator may help with information sharing to globally reduce risks among startups.

Cybersecurity is not just a best practice for large, enterprise companies, startup businesses are direct targets as they often have more risk and vulnerabilities and less resources to protect themselves. Anders Technology Services works with startups on identifying risk and developing a personalized cybersecurity plan. For more about the cybersecurity resources available to startups and how to protect your business, contact an Anders advisor.

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September 10, 2019

Startup Fundraising 101: Convertible Notes

Deciding how to finance your high-growth startup company is important. Most startup companies rely on outside sources of financing, and there are many forms of capital that investors can provide. One of these forms is a convertible note.

What is a Convertible Note?

Convertible notes are a hybrid between debt and equity, with the initial structure being a debt investment. These notes have a provision that allows, at a later date, the principal and accrued interest to convert into an equity investment. This structure is beneficial because the original investment can be done faster and is cheaper due to lower legal fees, but allows the investor to receive the economic benefit of an equity investment.

Components of Convertible Notes

There are several components that make up a convertible note. These components include:

Maturity Date: Convertible notes have defined maturity dates, which makes the note due to the investor if the note has not been converted to equity. In some cases, notes are automatically converted at maturity.

Interest: Like every other debt investment, the funds in a convertible note produce a rate of interest that accrues over the life of the note.

Conversion Provisions: The most common method of conversion happens when qualified financing occurs. Qualified financing is when a certain threshold is exceeded by a subsequent equity investment. At this moment, accrued interest plus principal converts into shares of the new equity that was just sold. This typically provides note holders with more shares than they would have received if they waited for the equity round of financing.

Conversion Discount: Investors usually receive a discount on the price per share of the new equity purchased after a qualified financing event.

Valuation Cap: A hard cap on the conversion price for noteholders, regardless of the price per share on the next round of financing. Conversions that occur automatically on the maturity date are usually lower than the valuation cap.

Pros and Cons of Convertible Notes

Pros:

  • Since seed-stage companies do not have enough operating experience to properly evaluate the company, convertible notes avoid placing a valuation on the company
  • Good bridge-capital financing options
  • Less expensive and faster to execute because they are simpler to legally document

Cons:

  • Companies could be pushed into bankruptcy if future equity rounds do not occur because the note will still be redeemed as debt
  • Price expectations from valuation caps could complicate future equity rounds
  • To avoid the issue mentioned above, terms and conditions can be set for convertible notes. This may defeat the purpose of the convertible note and end up taking as much time and effort as equity financing

Convertible notes encompass the best attributes of both equity and debt investments. If utilized properly, they can be a powerful method to raise capital, but it is important to understand all of the implications of convertible notes. Startup companies should weigh all of the pros and cons of all investment options to determine which one is best for fundraising. Contact an Anders advisor with questions on how convertible notes can help fund your startup company, or learn more about the Anders Startup Group.

Learn about other types of fundraising options in our post on Startup Fundraising 101: Fundraising Options.

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August 8, 2019

Startup Fundraising 101: Funding Options

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.

Debt Investments

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.

Equity Investments

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

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.

SAFE Agreement

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.

Crowdfunding

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.

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