• July 26, 2016

Financing for Startups: Venture Debt, Equity, & Convertible Notes

Financing for Startups: Venture Debt, Equity, & Convertible Notes

For startups and high-growth businesses, as you scale and face new business milestones and obstacles, you will be faced with the question of how to finance and plan for that growth. Luckily for founders, the ways in which you can finance your startup are varied based on your business model, your preference, your goals and timeline, etc. There are a range of options from venture debt, to equity financing, to convertible debt and more.

Financing for Startups: Venture Debt, Equity Financing, & Convertible Debt

We hold dozens of free business consultations a day to help growing businesses find the right vendors. We’ve worked with hundreds of startups that have various business plans and financial models to figure out what their best plan of attack is for financing.

When providing financial recommendations, we usually start by explaining the differences between the various financing options and apply them to their specific situation: equity financing, convertible equity, business loans, lines of credit, venture debt, and more.

Let’s start by digging into the types of financing, how a business can go about securing that financing, and how each typically impacts a high-growth business.

Unsure which financing option is best for your high-growth business? Sign up for a free business consultation with one of our business advisors and we will point you in the right direction immediately.

Equity Financing

For high-growth businesses, predicting cash flow (and the ability to pay back debt) is very difficult. As such, most founders prefer the familiar financing model with venture capitalists, which is to receive funding by issuing stock to those investors. Your revenue/profit can change very quickly so angel investors and venture capitalists typically secure equity to fund your growth.

An important consideration when issuing stock is the difference between common and preferred stock. Common stock, as implied by its name, is generally the most common type of stock issued by companies, though terms and features can differ based on the issuing company. As your company grows, your company stock appreciation does as well, and shareholders receive dividend payments over time (especially for later stage rounds; not typical for early stage). Preferred stock is typically how VCs receive stock as it allows them to receive the proceeds of an exit before common stockholders. While common stock can be volatile, this also means it can be more likely to appreciate over preferred stock. That being said, preferred stock is typically the first to be paid out before any dividends are paid on common stock. We highly recommend reading up on all things term sheets with our detailed post, The Ultimate Guide to VC Term Sheets and Negotiations.

Convertible Debt

For high-growth businesses, convertible notes are a good alternative to equity financing and as SeedCamp pointed out, a good compromise for both investors and buyers. The note is a loan, so investors aren’t as protected as an equity holder, but if the company raises money, rather than pay back the investor in cash, the principal and interest are paid back by being converting into shares of stock. (“In other words, the investor enjoys the downside protection typically associated with debt lenders, but is also positioned to enjoy the upside opportunity typically enjoyed by equity holders.”) Convertible debt is used many times during seed stage and bridge rounds of financing. As soon as those early stage companies raise a series A round of financing, that debt converts into equity at a discount.

This is important because it means companies can get the deal done a lot faster than with a typical equity term sheet and also lets them put off a formal valuation discussion. The downside? A discount of anywhere from 15-25% is typically placed on the equity. Also, a cap must be negotiated at the time of signing to ensure investors get their minimum percentage of equity and enjoy the upside of their investment. If you’re growing at a healthy clip and meeting your goals, your valuation should exceed with series A, B, C funding that will make the discount issue moot.

Additionally, there are typically maturation deadlines, which means if the startup hits certain milestones, but hasn’t raised their next round of funding, they still have to pay back their investor with equity – regardless of if it exists to give. This makes convertible debt a really attractive option to early stage startups, but can present major issues down the road without the success and revenue milestones needed to pay off said debt before raising another round.

Worried about debt default? Some investors are offering convertible equity, which is very similar, except the investor does not need to be repaid and doesn’t accumulate interest. This TechCrunch article talks a lot about the benefits of convertible equity for ventures, but basically, it’s classified as “qualified small business stock” with less tax benefits for investors so the need to repay with interest can be refocused back into the business.

Venture Debt and Business Loans

We covered Venture Debt 101 for Startups in great detail but essentially, it provides a very cost-effective way to receive lended capital from a big financial institution IF you have liquidity and/or existing financial backing from a well-known investor. Banks will loan to startups that have access to the pockets of institutional investors, like a well-known VC firm, or that are generating a certain amount of revenue that will fool-proof their investment.

The downsides of venture debt? While the interest rate is low, there is a lot of reporting to the banks that goes into the deal on a monthly basis. You’re essentially opening up your financial kimono to a new entity, which might be viewed as a negative to many growing businesses (think monthly income statements, balance sheets and compliance certificates, annual tax returns, collateral audits, and more). There are also a good amount of legal fees that go into procuring the deal. Check out our Venture Debt 101 for Startups blog to learn more about typical numbers and rates around repayment, interest rates, warrant coverage, rights to invest, covenants, and more.

If venture debt doesn’t appeal to you or your business model, you can check out other types of loans available to small businesses:

  • ROBS – Rollover for Business Startups is exactly what it sounds like, you are borrowing up to 100% of your retirement savings. According to the SBA, once incorporated, have your corporation set up a qualified retirement plan and rollover your 401(k) – all tax free – and the plan then buys shares/becomes owner in your corporation. Downsides besides putting your retirement money into a startup (which don’t always have the best success rates!) are the costs associated with setting up the plan and increased scrutiny by the IRS.
  • Personal loan – If you’re having trouble getting a business loan through a bank, a personal loan can be easier to secure, but obviously, much more of a risk to the individual.
  • SBA guaranteed loan – This is a great option if you qualify. SBA loans are known to be hard to get – they require lengthy paperwork and an even longer time to get approved. But, if you get one, they have lower rates and easy and flexible payment terms. To get started, you’ll need a business plan, a credit report, financial statements, tax returns, collateral, legal documents, accounts receivable and payable details, and more. There are 12 SBA loan programs for you to investigate and each program details who should apply, what the qualifications are, and why.

Lines of Credit

Business lines of credit are looked at as an easier way to get access to debt – it’s unsecured so you don’t need to provide a lot of the materials or collateral that you need to provide for a loan. The difference between a line of credit and a business credit card? It’s more expensive. With a line of credit you can take out a maximum and only pay interest on the money borrowed. Again, SBA provides a great overview of the best types of business lines of credit based on your unique financial situation.

So, how can you be sure which option is best for your business? Conduct a pros & cons assessment by asking yourself these 5 questions:

  1. When do I need this financing? If you need it immediately, you might go with convertible equity or a line of credit. Options like SBA loans, equity financing, and other loans might take longer to secure and require significantly more effort.
  2. How much capital do I need? If you need a large amount of money, traditional equity financing through a VC might be your best bet. Smaller amounts can be secured through venture debt, personal loans or lines of credit.
  3. Do you plan on relying on outside financing moving forward? If you plan on being profitable in a short amount of time, your financing should reflect that timeframe. Some business owners will want to remain as independent as possible from financing stakeholders and investors if their revenue model will allow it.
  4. Do you want others to have ownership in your business? Similarly, if you don’t need ongoing capital infusions, you might not want capital from an investor who will become a stakeholder and someone you have to answer to in the long-term.
  5. Are you financially stable enough for certain types of financing? This is a pretty cut and dry answer. Look at the financial requirements of some loans, or for venture debt for instance, and figure out if you are making enough money to qualify or will feasibly be able to repay a loan by deadline, etc.

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