Have You Considered All Of Your Startup Financing Options?

Startup Financing Options: Debt vs Equity

Startups able to secure initial outside financing are often presented with different mechanisms by potential investors for taking in the outside investment funds. When reviewing term sheets presented to them, it is imperative that startup founders be able to fully understand the terms. There are several different types of financing structures that may be available for initial startup investments that, in some manner or form, involve some combination of equity or debt. Startups should be aware of the relative benefits and disadvantages of taking on debt versus taking in equity.

Equity

Equity financing involves investors providing the startup with capital in exchange for an ownership stake in the startup. Equity can be structured in a variety of different ways and depends on your business entity structure. Often, investors require terms that give them enhanced voting rights, stock preferences (i.e., rights to a faster return on their capital in certain circumstances), board appointment rights, anti-dilution protections, preferred rights on liquidation and other elements of control to protect themselves.

Startups need to know where such investor demands go too far (don’t make sense for their particular business opportunity) and where they are reasonable. The rush to take in early investment money can lead to decisions regretted later on.

One advantage to equity is that it aligns the interest of investors and startup founders in improving the valuation of the business – it isn’t just about recouping debt and collecting interest, so equity investors may be more invested in the success of the business. Equity investors in early startups may be more inclined to provide a useful role beyond straight cash, such as providing guidance, expertise and introductions.

One disadvantage of equity over debt is that investors taking an equity position invariably leads to dilution of the startup founders. Determining the value of the equity presents a negotiation point that can sometimes cause friction between investors and startup founders that can be avoided (or, at least, punted) by offering convertible debt instead. 

Debt: Convertible Notes

While it may be possible to obtain financing in the form of straight debt, with an interest rate and maturity, more often early investors into a startup will want either a piece of the equity (an equity kicker) along with the debt, or, more commonly, invest in the form of a convertible promissory note obligation.

A convertible note has features that are part debt and part equity. Initially, it functions as debt. However, under certain circumstances defined in the note obligation, the balance owed on the note will convert to equity. The note must set out the formula for the conversion rate which must be negotiated carefully, as well as the conditions for the conversion. The formula for conversion is usually structured with deferred interest payments that are absorbed upon conversion of the debt and interest into equity.

Equity prices may rise from when an investor first takes a risk on a startup and when the note converts, so investors are sometimes given a discount rate on the equity price upon conversion (for example, investors may convert at a value approximately 20 percent lower than the market value at the time of conversion). Other structures, especially where there is significant interest by investors but an inability to agree on the company value and a further round for a larger investment sum is contemplated upon the company achieving a developmental milestone, allow for or require conversion of the debt upon the subsequent round of financing and at the same price for equity as is paid in the subsequent round.

Convertible notes have certain advantages over equity for startups. Because no equity valuation is needed to close, deals typically close more quickly and cost less in terms of legal fees. Convertible notes also preserve flexibility. Most notably, the ownership interests of the founders are not diluted until a later date (and if the note is repaid, may not be diluted as much or at all).

What’s Best for Your Startup?

Convertible debt and equity rounds each have pros and cons. That’s why they are often the subject of intense debate in the startup industry. A 2015 survey of Angel Capital Association members revealed the following:

• 82 percent preferred to do priced rounds for their initial investments 
• 78 percent had done at least one convertible note in the last 18 months
• 25 percent had used convertible notes for more than half of their first investment deals

While it appears that equity is the more common mechanism for early investment in startups, convertible notes offer advantages to both investors and startups and should be considered. More complex structures than the simple terms outlined above also are available. For example, a recently developed alternative structure for seed funding is a SAFE (Simple Agreement for Future Equity). The standard SAFE is an agreement between the investor and the start-up for a cap on valuation that allows for the investor to provide necessary capital, after which they await a specific event, such as an equity financing round, sale of the company, liquidation, or dissolution to trigger conversion of the investment into equity. Variations from a plain vanilla SAFE abound, including: an investor discount on conversion; a valuation cap and a discount; or a most favored nations structure which allows the early investor to remain on par with subsequent investors. A SAFE can be simpler to negotiate than a convertible note transaction, and does not function as a debt instrument, so there is no concern about meeting a maturity debt obligation or the payment of interest.

When negotiating with potential investors, it is important for the start-up entrepreneur to have advisors familiar with what is market and the options available.

Do you have any questions? Would you like to discuss the matter further? If so, please contact me, Jeffrey Cassin, at 201-806-3364.