What Type of Security Should You Use to Fund Your Venture?

June 26, 2018 Published Work
The National Law Review

You're an entrepreneur looking to fund a new company. How should you finance your venture? In this article, we review the most common types of securities used in financing emerging companies, and highlight key issues worth considering for each.

Equity

One common option for funding a new venture is to issue equity. In other words, a founder can sell shares of the company to an investor at a set price. The parties arrive at a valuation of how much the company is worth. Once the terms of ownership are set and payment is exchanged, the investor is brought on as an additional owner of the company.

A straightforward benefit to issuing equity is that you receive funding without any debt to pay back (note, however, that some shares may have an attached redemption right, which obligates the company to repurchase the shares if exercised by the shareholder after a certain period of time). Another advantage is clarity – you know exactly what percentage of the company the investors are getting for how much, and on what terms.

Frontloading these decisions about the specific terms of the investor's stake does add complexity to the transaction. Perhaps most thorny is determining the company's valuation, which at the pre-revenue stage is more art than science. Also, institutional investors generally want preferred stock, with attendant rights such as liquidation preferences, protective and participation rights, and board seats. These rights serve to protect the investor's interest through the ups and downs of the company's life, but can be onerous for founders. Each right must be thought through by the company with an eye toward the future, and negotiated, to the extent the appetite (and legal budget) is present.

Operationally, issuing equity means that the company has additional owners, often permanently. The founders' share of the company will be diluted. Investors often demand board seats, which may mean rights to information about the company and some influence over how the company is run. This can be a positive event for the company; an investor may add value by being more involved in operations or fundraising, or providing industry advice, connections and mentorship. Alternatively, the investor may have unrealistic expectations or have different ideas than the founders for the direction the company should go, which can become additional hurdles for a young company. Finally, there is an administrative burden associated with additional owners: obtaining approvals can become more cumbersome, and accounting and other administrative services more expensive.

In any event, issuing equity entails a degree of permanence: you can't get rid of your shareholders (and buy back your shares) as easily as you might your lenders. If you do choose to issue equity, ensure that your shareholders are credible investors who bring value to the company, and that you are comfortable with the amount and terms of their investment.

When to use it:

  • Your company has positive indicators for a strong valuation (e.g. high, sustained growth, desirable technology)

  • You have confidence in the investor and the value they bring to your venture

  • You have the resources to understand the terms of the agreement and push for a beneficial outcome

Convertible Debt

Another (very) common vehicle for financing startups is convertible debt. Like conventional (non-convertible) debt, discussed below, the investor provides cash to the company that accrues, with a maturity date for when the loan comes due. However, in contrast to conventional debt, if all goes as planned, the parties generally don't expect the company to pay the loan back. Rather, the note provides that the principal (and typically the interest) will convert into equity (typically, preferred) in a future equity financing. In contrast to straight equity, the parties delay valuing the company, and thus the price per share, until the future equity round. Convertible debt is often a more feasible option than equity for a founder who needs time to de-risk his or her idea before being able to obtain equity investors willing to invest at a more company-friendly valuation, if at all.

To trigger the conversion of debt to equity, the parties typically negotiate a minimum amount that the company must raise in the equity financing (often called a "qualified financing"). The maturity date and qualified financing threshold provide benchmarks for when the equity financing should occur, how large that round should be, and potentially even the sophistication of the investors. Although the intent of convertible debt is that the loan not be repaid, this depends on the company raising sufficient investment to trigger conversion. If the company fails to reach a qualified financing, founders can face consequences similar to those related to failure to repay straight debt, such as default and foreclosure. Founders will therefore want to make sure that these benchmarks align with the company's business plan.

Another key aspect of convertible debt is the size of the investor's ultimate investment. Convertible debt rewards investors for supporting early-stage, higher-risk companies through discounts and valuation caps. Typically, investors receive a percentage discount off of the price per share paid by cash investors in the qualified financing. Investors sometimes also, or alternatively, demand the inclusion of a valuation cap, whereby the investor sets the maximum company valuation at which the debt converts to equity. If at the equity round, the company has a higher valuation than the cap, then the debt still converts at the valuation cap, thus receiving a discount. When a company's valuation increases significantly above the valuation cap, it provides tremendous upside for investors, and its effects may be shocking to founders who may be diluted substantially by the conversion.

For this reason, while negotiating a convertible debt instrument is generally faster and cheaper than straight equity, the several issues that the parties tend to negotiate heavily – including the valuation cap, discount percentage, interest rate, maturity date and qualified financing threshold – can end up having important ramifications. An entrepreneur who chooses convertible debt for its efficiency and rushes through these key terms can end up giving away a bigger chunk of the company than anticipated.

Finally, founders should note that convertible debt, like straight debt, may come with strings attached. These include operational restrictions, investor protective provisions and security interests (i.e. the right to foreclose on collateral if the loan is not repaid). Founders should take care to evaluate these provisions to the extent possible, in order to align the terms of the loan with the company's goals.

When to use it:

  • Your company is at a stage where valuation is difficult to determine

  • You need cash and growth to attract potential shareholders in the near term

  • You have done the homework and are comfortable with the potential range of the investor's share

Other Convertible Instruments: the SAFE and the KISS

The Simple Agreement for Future Equity (SAFE) and Keep It Simple Securities (KISS) each refer to specific form documents for convertible equity designed to be simple and produce quick, efficient transactions. They were both developed by startup accelerators in the 2010s (by YCombinator and 500Startups, respectively) interested in creating easy-to-use standard forms that balanced founder and investor interests.

Like convertible debt, these documents are convertible instruments through which an investor gives money to the company at closing, for the promise that the investor will be given a to-be-determined number of shares at a future financing. Also like convertible debt, the parties often negotiate the inclusion and amount of a discount and/or valuation cap.

However, the SAFE and one version of the KISS (the "equity version") are generally not considered debt instruments. The investors give the money in exchange for the promise of future shares only. There is no obligation for the company to pay the money back. Thus, interest does not accrue, and there is no maturity date (The KISS is made available in an equity version and a debt version – the debt version does include an interest rate and maturity date). The lack of debt-like features removes some of the pressure on the company with respect to the timing of its next financing. Note that this doesn't mean that the investors can never collect if the company fails to reach financing – if the company gets acquired or dissolves, the investors are generally entitled to recoup their investment, or a multiple thereof.

For founders, a major benefit of these form documents is that they are short, available for free, and have a recognized reputation. Keep in mind, though, that the efficiency of any convertible instrument comes at the cost of uncertainty. Due to their relative novelty, the courts have not developed a body of law for SAFEs and KISSes (yet), and not every investor will be familiar (or comfortable) with these documents – the company may have to help an investor develop comfort.

More generally, founders should not let the standardized veneer of these instruments keep them from negotiating for terms that are favorable to the company. Strive to understand the terms of the agreement and how they may be adjusted for your particular circumstances. If you're short on negotiation capital, you might focus on impact items such as the valuation cap, pro rata rights, and "most favored nation" status.

When to use it:

  • You have an investor who is comfortable with these instruments

  • You need cash and growth to attract potential shareholders

  • You have limited resources

  • You want flexibility on when to hold the next financing and do not want a maturity date to dictate the date for it

Debt (Non-Convertible)

There are also several options for founders who want funding but wish to avoid diluting their stake in the company. One such option is conventional debt, generally from a bank or other financial institution. The company borrows money now and pays it back later with interest.

While it is often difficult for startups to qualify for a conventional business loan due to a lack of business and credit history, there are a variety of loans specifically targeted at new businesses. These include equipment loans, business credit cards, microloans of very small amounts, and loans from the Small Business Administration (SBA). Many of these loans have more flexible requirements for qualification, and the company may also be able to deduct the interest from its taxes.

Taking out a loan rather than selling equity keeps the company under the founders' control, provided the loan is repaid, and typically does not entitle the lender to future profits of the company. However, straight debt may be difficult to qualify for, especially for pre-revenue companies. Moreover, as discussed, debt also comes with stipulations such as operational restrictions, protective rights and security interests, which are often more restrictive and harder to negotiate with straight debt than with convertible debt.

Whether taking on a loan makes sense also depends on the company's anticipated revenues and ability to meet payment deadlines. A targeted loan may be ideal for a startup that expects steady profits. But be mindful that overleveraging your company with debt can be a drag on future valuations of the company. Missing payments can cascade into negative consequences such as payment penalties, difficulty securing financing in the future, and even an impact on the founders' personal credit scores.

When to use it:

  • You value keeping the company closely held

  • You have predictable revenues but low growth

  • You qualify for a loan that meets a specific purpose

Government and Institutional Grants

Grants are another non-dilutive funding option that can be useful for early-stage companies, to the extent they are attainable. Typical sources include domestic and foreign governments and institutions.

Well-known federal options include the Small Business Innovation Research (SBIR) grants and Small Business Technology Transfer (STTR) grants. While both of these are coordinated by the Small Business Administration (SBA) and targeted towards companies engaged in high-tech and R&D-related ventures, a variety of grants are available through a number of different agencies and target different concerns. An updated list is available on grants.gov.

One agency worth noting is the Pentagon's Defense Innovation Unit Experimental (DIUx), which solicits proposals on topics relevant to Department of Defense entities, and awards funding to selected companies.

Foundations and other institutions with a particular interest in a company's industry may offer grants for technological progress in an area that investors are unwilling to fund. Founders should note that tax-exempt status is often required for grants offered by private institutions.

The key benefit of a grant is that the company typically need not issue any equity or repay the grant. That being said, grants may be difficult to find, can require time-consuming research and paperwork, can move at a glacial pace, and may have very specific requirements (for qualification or use). Founders should make sure that the pace and restrictions of a grant fit into their business plan.

When to use it:

  • You value keeping the company closely held

  • The timeline and application requirements fit your business plans

  • You have a backup plan if your application does not succeed

Bootstrapping

Last but not least, many great companies were funded by their founders (and their founders' credit cards). For those that are unwilling or unable to find investors, and have the means to bootstrap, self-funding ensures that the founders will remain in the driver's seat and motivated to succeed. The risks are obvious: if the enterprise fails, a founder's investment goes with it. The rewards, however, can be great.

When to use it:

  • There is a good fit between your resources and your goals for the venture

  • You are mentally, emotionally, and financially prepared for the financial risks

As you can see above, when it comes time to finance your company, you have options. The financing instrument you choose will depend on a variety of factors, some of which are out of your control. It is always a good idea to understand how the instrument works, so you can make an informed decision about which method to pursue. Once you've chosen a financing path, focus your efforts on negotiating the terms that will have most impact on the future of your company.


This article is part of a series called, "Legal Issues for High-Growth Technology Companies." Please click here for more information.