Fundraising Alternatives for Startups
08 May 2023 / Devin O'Donnell
Fundraising Alternatives for Startups
For many founders, fundraising can seem confusing and complex because of the number of alternative structures and their potential implications. However, many founders also find that they need to raise capital to take their ideas and turn them into businesses. In this post, we will highlight some of the most commonly used instruments and frameworks used to finance early-stage companies, along with the pros and cons of each structure, from the company’s perspective. For the purposes of this post, we are highlighting the typical financial structures and instruments used when raising capital from friends and family, angel investors, family offices, and venture capital firms, but we will not be discussing other forms that may be available to founders such as loans from banks or the United States Small Business Administration. This post assumes that the company is formed as a corporation under state law, but the forms of financing discussed can be used in a similar fashion by a limited liability company.
Common Stock
Common Stock is the simplest form of equity that can be issued in an early-stage company. Common Stock is typically the same form of equity granted to a company’s founders and grants the investor basic stockholder rights such as the right to vote, receive dividends, inspect the company’s books and records, and receive a pro-rata share of the company’s assets if the company liquidates. As compared to Preferred Stock, Common Stock is generally issued to less experienced investors who do not insist on the rights and preferences granted to the holders of Preferred Stock, which are discussed below.
Pros:
- Relatively simple and inexpensive to document
- Does not grant the investors rights and preferences that could hold up the company in the future
- Allows the investors and founders to know their exact ownership percentage
Cons:
- Can be difficult to obtain an accurate company valuation and price per share, especially if the company has a limited operating history
- Can dilute the company’s founders to the point where they lose voting control
- State law generally grants stockholders the right to inspect the company’s books and records, which can become burdensome
Convertible Preferred Stock
Convertible Preferred Stock, often referred to as just Preferred Stock, is a more complex form of equity that is typically issued by more established early-stage companies. Holders of Convertible Preferred Stock are generally granted additional rights and preferences that are not granted to the holders of Common Stock. Early-stage companies typically issue investors Convertible Preferred Stock in the form of Series Seed Preferred Stock or Series A Preferred Stock. Series Seed Preferred Stock generally grants the investors fewer rights and preferences than Series A Preferred Stock. Series Seed Preferred Stock is typically issued if the total size of the financing round is under $3,000,000 and Series A Preferred Stock is issued if the total size of the financing round is over $3,000,000 and usually depends to a large extent on the sophistication level and relative leverage of the investors. The rights and preferences granted to the holders of Convertible Preferred Stock can include a liquidation preference, a right of first refusal and co-sale, anti-dilution rights, the right to convert to common stock and the right to designate members of the company’s board of directors. Convertible Preferred Stock is generally issued to more experienced investors and venture capital firms who insist on the rights and preferences granted to the holders of Convertible Preferred Stock.
Pros:
- Typically allows the company to raise greater amounts of capital
- Can allow the company to raise capital from strategic investors who can help grow the company using strategic and operational expertise
- Can decrease the complexity and cost of future financing rounds
- Allows the investors and founders to know their exact ownership percentage
Cons:
- Can be complex and costly to document
- Can dilute the company’s founders to the point where they lose voting control
- Grants the investors rights and preferences that could lead to delay and complexity in the future
- Introduces new members to the company’s board of directors who may not have the same vision or goals as the founders or existing board members
Convertible Notes
Convertible Notes are a common form of financing for early-stage companies and exhibit characteristics of both debt and equity. Convertible Notes have all of the traditional characteristics of debt – a principal balance, interest rate, maturity date and priority senior to the company’s stockholders. However, Convertible Notes include certain conversion features, whereby the outstanding principal and interest are converted to equity upon the happening of certain conversion events. Typically, Convertible Notes convert to equity or are repaid as follows:
- The company closes a subsequent equity financing of a certain minimum size (“Next Equity Financing Conversion”).
- In the event of a subsequent equity financing that reaches the minimum size threshold negotiated in the Convertible Note, the holders of the Convertible Notes will typically convert into the same type of equity (typically Series Seed or Series A Preferred Stock) purchased by the investors in the next equity financing round. The holders of the Convertible Notes will typically receive a discounted price compared to the investors in the next equity financing round, which is determined by the valuation cap or discount rate negotiated in the Convertible Note.
- The sale of the company (“Corporate Transaction Conversion”).
- In the event that the company sells while the Convertible Notes are still outstanding, the holders of the Convertible Notes typically receive the greater of:
- The principal amount of the Convertible Notes plus all accrued interest; or
- A pro-rata amount of the sale proceeds payable to the stockholders of the company assuming the Convertible Notes convert to Common Stock immediately prior to the sale based on the valuation cap negotiated in the Convertible Note.
- Reaching the maturity date before the company reaches a Next Equity Financing Conversion or Corporate Transaction Conversion (“Maturity Conversion”).
- In the event that the Convertible Notes reach maturity before a Next Equity Financing Conversion or Corporate Transaction Conversion, the holders of Convertible Notes typically have the option to:
- Convert to shares of the company’s common stock based on the valuation cap negotiated in the Convertible Note;
- Demand repayment of the outstanding principal and accrued interest; or
- Leave the notes outstanding to accrue interest until a Next Equity Financing Conversion or Corporate Transaction Conversion occurs.
- In the event that the Convertible Notes reach maturity before a Next Equity Financing Conversion or Corporate Transaction Conversion, the holders of Convertible Notes typically have the option to:
- In the event that the company sells while the Convertible Notes are still outstanding, the holders of the Convertible Notes typically receive the greater of:
Convertible Notes can be issued to any type of investor who understands the conversion mechanics and is content waiting until one of the conversion events to convert into traditional equity.
Pros:
- Relatively simple and inexpensive to document
- Does not dilute the company’s founders or grant the investors any traditional stockholder rights until conversion
Cons:
- The fully diluted ownership percentage of the founders and the investors is ambiguous because it is dependent on the terms of future conversion events
- Can lead to financial issues if the investors demand repayment at maturity
- Can lead to unexpected dilution at conversion if the company is not cognizant of the principal amount, discount rate, and valuation cap of the outstanding Convertible Notes
SAFEs
A Simple Agreement for Future Equity (“SAFE”) is an increasingly used form of financing for early-stage companies that is similar to Convertible Notes. SAFEs include similar conversion features as Convertible Notes, but lack the traditional debt characteristics of Convertible Notes, including a maturity date and interest rate. SAFEs include the same Next Equity Financing Conversion and Corporate Transaction Conversion as Convertible Notes, but do not have a Maturity Conversion, because they do not have a maturity date. The price at which a SAFE converts to equity is dependent on the price negotiated by the investors in the next equity financing, and the valuation cap and/or discount rate negotiated in the SAFE agreement. The main benefit of SAFEs, as opposed to Convertible Notes, is SAFEs do not have a maturity date, meaning the holders of SAFEs cannot demand payment at maturity when the company may not have the sufficient funds for repayment. SAFEs can be issued to any type of investor who understands the conversion mechanics and is content waiting until one of the conversion events to convert into traditional equity.
Pros:
- Relatively simple and inexpensive to document
- Does not dilute the company’s founders or grant the investors any traditional stockholder rights until conversion
- No maturity date
- No ability for the investors to demand payment
Cons:
- The fully diluted ownership percentage of the founders and the investors is ambiguous because it is dependent on the terms of future conversion events
- Can lead to unexpected dilution at conversion if the company is not cognizant of the investment amount, discount rate, and valuation cap of the outstanding SAFEs
Conclusion
When raising capital through the above-mentioned forms of financing, it is important to ensure that it the financing is documented correctly and done in compliance with federal and state securities laws.
It's time to consult with an attorney.
Let's discuss the optimal form of financing for your company, documenting the financing and ensuring compliance with securities laws...and more! Connect with attorney Devin O'Donnell at dodonnell@gravislaw.com or 406-412-4362.