Choosing the right financing structure is a critical choice for founders. Some begin with their life savings, others run a crowdfunding campaign, and, those eligible, often opt for a traditional loan. Other popular financing options include convertible notes, equity financing, and revenue-based financing. In addition to the economics of the deal, financings implicate many legal, tax, and regulatory issues. This article explores all of the above and breaks down the pros and cons of each.
Startups that bootstrap are financing the company through the use of personal funds (usually savings and credit cards). Owners pursuing this route aim to develop the product, bring the product to market, and then eventually use revenue to grow the business, all without giving up equity to investors. Many companies start by bootstrapping and then find they need to explore a bank loan, loans from friends and family, private equity, or venture capital financing. NastyGal, Thrillist, MailChimp, and Burt’s Bees are all examples of businesses that bootstrapped early on.
- Does not dilute equity ownership or control for the founders.
- Operating lean requires more disciplined decision making.
- Founders remain focused on the company, not fundraising.
- Attractive to future investors because it shows drive and credibility.
- Potential lack of capital and cash flow.
- Might constrain growth rate because of the lack of cash.
- Depending on a founder’s finances, this could put extra stress on the team.
- Might not allow for a paycheck for the founders.
- Often not sustainable if revenues aren’t quickly realized.
- Not sharing risk with anyone else.
Traditional Bank Loans
Instead of pursuing equity investors (e.g. angel, VC, or private equity), some companies qualify for a traditional bank loan with an interest rate (typically compound interest). This is a great option to avoid giving up equity and control, but is typically only available to credit-worthy founders with businesses that have assets to secure the loan.
There are microfinance and small business loans available to entrepreneurs that might not otherwise qualify for a traditional, bank loan. These lenders are more lenient, but will likely require a higher interest charge or hefty fees. Lenders like Kabbage, Lending Tree, and Colorado Lending Source support small business pursuits with lower interest loans. The Small Business Administration (SBA) connects entrepreneurs with lenders for traditional bank loans.
- Founders equity and control isn’t diluted.
- Immediate capital infusion into the business.
- Increase company’s creditworthiness overtime.
- Interest payments take money the startup could otherwise put into the business.
- Most lenders require a compound interest rate, which adds up very quickly.
- Hard to get if the company or founders do not have collateral.
- Loans are typically secured, so failure to repay could result in loss of business assets including intellectual property, computers, buildings, or other valuable assets.
Convertible note financing enables a business to quickly raise capital without negotiating a valuation for the company. In exchange for their investment, investors receive a convertible promissory note that converts into stock at a future date with a share price, economic rights, and control rights set by later investors. Prior to conversion, convertible note investors do not actually own stock or have voting rights.
There are vetted and widely accepted templates for this type of financing: SAFE, KISS, and techstars. The most important distinction is whether the template is an equity or debt convertible financing. In an equity deal, there is no maturity date or interest rate on the note. In a debt deal, there are additional investor friendly terms including an interest rate (~6%) and maturity date (~24 months) so the investor has recourse if a company does not raise a subsequent financing round. This means that by taking on convertible debt, founders risk having to pay a large lump sum upon the maturity of the loan (interest + principal), if the conversion does not occur.
Two important terms in most convertible notes, whether equity or debt, are the discount and valuation cap. Both serve to reward early investors. The valuation cap places an upper bound on the company’s future valuation for purposes of calculating the number of shares the investor will receive upon conversion of their note. This rewards early investors if the Company’s valuation jumps above the cap in the next financing round. A discount (~20%) is a percentage discount on the price per share paid by investors in the next financing round.
Opinions on the use of convertible notes vary. On one hand, Paul Graham, founder of Y Combinator, is a strong supporter of convertible financings, but, on the other hand, Fred Wilson, VC at Union Square Ventures thinks otherwise.
- Quick way to bring investment dollars into the company because legal documentation is light and avoids negotiation surrounding company valuation (less legal fees).
- Allows for “high resolution financing”.
- Readily available discount and valuation market comps on AngelList.
- Delays dilution of founder ownership and control.
- Delays valuation event which allows a company to continue issuing relatively cheap options.
- Will dilute control and equity when conversion occurs.
- Requires a big balloon payment at the note’s maturity, if equity conversion is never triggered and investors call the debt (shorter maturity = greater risk of default).
- Creates “technical debt” because the next equity round becomes more complicated and expensive.
- Liquidation Preference overhang.
In an equity financing, an investor provides capital in exchange for a set percentage of ownership in the company and specific control rights (e.g. board seat, protective provisions, pro rata rights). The three most common sources of equity financing are Angel Investors, Private Equity funds, and Venture Capital funds.
When sourcing investors, startups should try to raise from funds/firms that have both subject matter expertise and an extensive network in the industry. Additionally, if the investors want a hand in controlling the company (almost all will), the founders should be interviewing and reference checking the investors to make sure they’ll be a fit.
- Provides expertise and a larger network for the business to leverage.
- Infuses capital into the startup for growth.
- Increases clout and reputation of the startup.
- Generally accepted with relatively consistent norms across industry.
- Ownership percentages are certain.
- No interest payments.
- Dilutes founder shares, sometime immensely.
- Transfers control to external parties (i.e. venture capitalists) which often results in more complicated corporate governance.
- Require more time, money, and resources to get the deal done (generally).
- Giving up large chunks of equity can be the most expensive type of financing.
Revenue/Profit-based financing enables a business to exchange a percentage of their revenue or profit for money from an investor. Such investors see potential in the business, but do not want ownership or control of the business. Instead, the investor invests with the expectation of receiving a multiple (e.g. 3x) on their original investment repaid out of the revenues or profits of the business. Often, this type of investment agreement includes information rights, quarterly payments, a bonus payment if the company sells before the agreed upon multiple is reached, and specific reference that the investor will have no management or shareholder rights.
A successful Colorado company, P2Binvestor, facilitates an interesting twist on this model by partnering with investors and banks to provide asset-backed loans (traditional and revenue/profit-based) to entrepreneurs at below market rates.
- Provides for massive risk reduction (i.e. don’t have to worry about missing an interest payment or securing the debt with your personal property).
- Risk of default is low because payments are based on revenues, not a fixed amount. The investor will take a percentage of sales each week, month, or quarter to pay back the loan.
- No dilution and customizable to the parties wishes.
- Long-term cost can greatly exceed the short-term capital infusion.
- Less common option so there aren’t widely accepted norms.
- Company must have revenue or profits (many early stage startups do not).
Crowdfunding (Rewards-Based & Equity-Based Models)
Crowdfunding is a great way for a new business to test market validation. By sharing their product with potential customers, and providing incentives for their purchases, startups can raise capital to cover the cost of production while also ensuring the product has demand in the market. Crowdfunding can be rewards-based or equity-based.
Rewards-based crowdfunding sites like Kickstarter and Indiegogo simplify securities concerns and provide startups with a webpage to set a fundraising goal, provide purchasing incentives (i.e. buy one get one free), increase brand awareness with social sharing, and create a fan/donor base. Ouya, a gaming console company, hosted one of the most successful campaigns on Kickstarter by raising $8.5 million in 29 days.
Crowdfunding sites like Indiegogo/MicroVentures, Wefunder, and Crowdfunder all implement equity-based crowdfunding models. Equity crowdfunding implicates Federal and State securities law which means much greater compliance costs.
- Access to “cheap” money because no equity is exchanged (rewards-based only).
- Allows startup to “market test” the product: provides customer data and market validation (R&D).
- Increases brand awareness through social sharing capabilities.
- Does not dilute equity or control for the founders (rewards-based only).
- Gives company clout and increases attractiveness to future investors, if successful.
- Allows company to prepare for production and shipping costs.
- Requires operational efficiency to meet customer demands. Most crowdfunded businesses are late in shipping and create angst with customers/donors (also bad PR).
- Creates risk of failure and resource waste. These campaigns are expensive to put on successfully because of marketing, advertising, and legal costs.
- High legal and regulatory costs for equity-based crowdfunding.
- Funds may not be enough to bring the product to market.
Of course, each business is unique and requires professional counsel on the best financing option for its needs. This articles just scrapes the surface.