At some point, every company that decides to pursue outside financing faces a key decision: What kind of financing do I want or need? There are many choices a company can make, and figuring out what makes the most sense for you at that point and time can be a difficult task.
The two general categories you can decide between are equity and debt. Equity is the selling of an ownership stake in your company for a fixed price. The general term most people are familiar with when dealing with equity is “stock” (though this category is broad, and for LLCs and LPs, there may be units, membership interests, or simply percentages of ownership). Equity is not paid back (though investors may sometimes ask for a guaranteed return) and does not earn interest (though again, some investors may ask for guaranteed returns that mimic interest).
Debt is effectively an IOU—the investor gives you money as a loan and you are required to repay it at some point in the future. Debt earns interest over time and may also be secured by assets of the company (similar to a mortgage on a house) or guaranteed by individuals (meaning that, if the company fails to pay it back, those individuals are on the hook). One interesting feature of debt in company financings is some debt may be “convertible,” meaning that, rather than being paid back in cash, the borrower (company) pays it back by issuing some of its equity (stock) to the lender. Typically, convertible debt is automatically converted upon certain milestone events in the company’s life (e.g., a future significant sale of equity, a change of control in the ownership of the company or a sale of the company or all of its assets).
So why do companies decide to sell equity in some instances and debt in others? There are pros and cons to each and, for some companies, it is the investors who make the decision, as they clearly want one rather than the other.
For brand new companies seeking cash investments from friends and family, many often decide to sell equity. These smaller investments are typically from less sophisticated investors (this is not a comment on their tastes and manners, but their experience in startup investing); companies are able to raise this initial cash at a valuation of the company that does not significantly dilute the founders and lets their investors feel like they are truly getting in on the ground floor. The equity sold to friends and family investors is typically common equity (stock or units) and has no special rights, privileges, or preferences. These investors are on the same footing as the founders when it comes to their equity holding and will always be junior to later investors who buy different preferred classes of equities in greater amounts and at greater valuations.
Sometimes, these initial friends and family investors will purchase convertible debt from the company, which some businesses prefer because it allows them to, for the time being, keep 100 percent of the equity. These convertible notes often are quite simple—setting a relatively low interest rate (somewhere between six and 10 percent) and convert upon the sale by the company of future equity in an amount of at least some relatively small number (perhaps $250,000—sometimes less, sometimes more). The other primary reason companies sell debt to their friends and family is they do not want to have a discussion about valuation of the company at that early stage and, further, do not want to end up giving away too much value for relatively small investments. Of course, these decisions must be discussed and agreed upon with potential investors.
As companies grow and start to seek larger amounts of financing ($250,000 to $2.5 million), they will begin thinking about seed rounds. These rounds are often funded by angel investors or very small VCs with angel-type investment criteria (e.g., pre-revenue or very early revenue). At this point in the company’s life cycle, there are several options for financing:
Equity: Typically a company will sell either additional common equity or may create a series seed, which is more like a preferred equity-light. Series seed stock often has some additional rights (perhaps board observer seats, regular informational reporting, or the right to get certain future rights given to later rounds of preferred stock). Series seed do not usually have much in the way of liquidation preferences (meaning who gets paid out first in the event that there is a big cash payment coming to stockholders), but this also depends on the level of sophistication of the investors, or the level of perceived risk.
Convertible Debt: As with friends and family, this is a common route companies take for these seed-stage investments. In our experience, the majority of companies seek convertible notes in today’s market, which—again—allows them to keep a cleaner equity ownership structure (also called a capitalization table or cap table). While, historically, companies have sought convertible notes to delay the discussion of current valuation, the market has shifted to a model of conversion caps, which, in effect, are a proxy for the current value of the company at the time of the sale of the convertible notes. There is a lot more to discuss on conversion caps, but the gist is that, if the company sells future equity at an amount higher than the current valuation (which is the goal), then the convertible debt will convert into that future round of equity at a price that is equal to the current valuation of the company. So, for example, if a convertible note has a conversion cap of $3 million (meaning each share today is worth $3.00) and, in the future, the company sells equity at a $6 million valuation (or $6.00 per share), then the current debt will convert into that future equity at the price of $3.00 per share. This represents a 50-percent discount to that future price and is quite a deal for investors! Of course, investors see this as payment for the risk they take for putting in their investment today.
SAFEs: SAFE (Simple Agreements for Future Equity) were created by Y Combinator as a way to standardize early investments so there is not a lot of negotiation between companies and investors, as well as to put all of the investors on the same footing. While SAFEs have gained in popularity in some parts of the country (namely California), they have not quite caught on everywhere. You can think of a SAFE as a convertible note without any interest and without much negotiation. Investment documents for SAFEs have been standardized and are often a “take it or leave it” proposition.
Bank Financing: Some companies decide pursuing a bank loan is the best way of providing the capital they need to grow and scale their business. For earlier stage companies without real revenue streams, founders should expect they will not only need to secure these loans with the assets of the company (so that if the company defaults on the loan, the bank can foreclose on the assets), but also, particularly for tech companies whose assets are not concrete, personal guarantees by the founders. Some banks, such as Silicon Valley Bank and Square 1, are aimed at the startup market and focus on earlier stage companies. Companies that take out bank loans should, however, be aware that they will typically have covenants, reporting obligations, and higher interest rates which they would not have if they were selling debt to individual investors.
There are obviously other stages at which companies seek financing, and there are many considerations at each of those stages regarding the types of financing that may be available. For the earliest-stage companies, however, having at least a basic understanding of the world of fundraising options is a great first step in taking the plunge into raising cash and growing quickly.