While the entrepreneur’s focus may initially be on who can provide the capital to help the startup grow, the entrepreneur must also consider what form the funding will take, what the instrument of investment will look like, and what the impact of obtaining outside capital is on the company over time.
Typically, funding types are categorized as equity or debt, although alternative funding types, such as grants, can prove to be the ideal source of capital for the entrepreneur. Before determining what form of investment is right for the company, consider the implications of decisions around the capital structure and capitalization table specific to your company.
Important topics related to investment instruments include:
- Capital Structure
- Capitalization Table
- Equity Financing
- Debt Financing
- Alternative Financing Sources
Capital is the worth or value of a company in the form of resources that enable a company to operate and grow. The capital structure of a company reflects the composition of a company’s capitalization in terms of (1) Equity Capital and (2) Debt Capital.
Equity Capital – cash received in exchange for ownership in the company
Debt Capital – cash received in exchange for future interest and principal payments
Startup founders have the choice to determine how their company is capitalized and what ratio of the capitalization will come from debt vs. equity. Earlier-stage companies often will not have access to debt financing due to the risk of failure embedded in any startup company and/or the lack of the company’s or founders’ performance track record.
The capital structure of a company is tracked by maintaining a capitalization table (“cap table”) document evidencing all of the company’s securities, including details such as investor names, share class owned, issuance price, rights & preferences associated with the shares, and a number of shares held by each investor. The cap table is one of the most important documents maintained by the startup because this dictates who owns what and how ownership may change over time.
Early-stage investors prefer to invest in companies with a “clean” cap table, meaning simple ownership structures with minimal rights & preferences to early shareholders (i..e., founders, friends & family, or angels). As the startup raises subsequent rounds of equity funding, the cap table can become quite complex. Having a clearly-defined cap table will help the founders plan for the future and understand the potential impact on or dilution of their ownership upon future rounds of funding.
Equity represents ownership in a company. When a team of founders start a company, typically, the founders collectively start with 100% equity in the value of the business. When the founders choose to seek outside capital by giving up equity in the business, they are giving up a percentage of ownership in their company for a specified amount of money. This is known as dilution. The percentage given up and amount of cash received will vary each step of the way.
Stages of Equity Financing:
Just as the startup’s business evolves in stages over time, so too does the funding of the startup. The startup founders must focus on business goals in parallel with funding goals. Startup funding has a specific purpose for each step of the journey. The founders must know what stage the company is in, how much capital is needed, and what the funds will be used for before they can know who the right investors may be and what terms those investors may seek.
Equity Funding Stages Throughout the Startup Lifecycle:
There are many different paths a company may take through their lifecycle. For example, some startups may never get to an IPO as they may be acquired by a strategic buyer while still a Series A company. Conversely, some companies may go well beyond Series C — like Uber who IPO’d after Series H.
These details represent a simplified example of the hypothetical path of a startup from pre-seed through IPO:
Pre-Seed: Bootstrapping and Friends and Family:
Seed Funding: Product Development/MVP
Series A: Product & Business Model in Place
Series B: Product-Market Fit & Scale
Series C & Later: Product & Market Expansion/Growth Equity
IPO/SPAC/M&A (Exit Event): Established Business with Strong Financials and Governance
While equity instruments vary in the complexity of their features, they each provide the holder of the instrument the same fundamental thing: ownership in the company.
The four most common types of equity instruments are:
- Common Stock
- Preferred Stock
- SAFE Note
Common Stock is typically referred to as Founder’s Equity in the cap table of a startup. Common stock is the most junior stock and does not carry with it enhanced rights or preferences. Common stock can carry with it voting rights. Common stock is referred to as Founder’s Equity because in a startup, external investors would typically expect to have certain enhanced preferences or downside protection.
Preferred Stock is typically provided to external startup investors in exchange for their capital. Preferred stock has enhanced preferences which includes seniority in the capital structure, liquidation preference, anti-dilution provisions, dividends, conversion features, and participation in upside value.
Common vs. Preferred Comparison:
These resources can help to show the differences between common and preferred stock.
Stock options are granted for various reasons and entitle the holder to exercise the option at a set price in order to convert the option into a share of corresponding equity stock shares. In simple terms, this is a call option. Options can convert into common or preferred stock. The terms of the options are defined upon issuance. The typical features of options include numbers of shares, strike price, and time to expiry.
Startup founders should consider establishing an equity pool upon the initial structuring of the capitalization table in order to account for future equity or option compensation needed to attract and retain talent. The equity pool is part of the legal structure comprised of options to be used as incentive compensation. Employee stock option plans typically result in the issuance of either incentive stock options (ISOs) or non-qualified stock options (NSOs) subject to a vesting schedule. As an alternative to option grants, companies may choose to issue Restricted Stock Awards or Restricted Stock Units.
Warrants are similar to stock options in that they represent the right to buy a share of stock at a defined stock price at some time in the future. Warrants are dilutive, and when exercised, new stock is issued to the warrant holder. Warrants are commonly used as “kickers” or “sweeteners” in a debt financing or preferred equity financing structure to allow for the primary debt or equity instrument to carry better terms for the startup (i.e., lower coupon on a debt instrument or lower PIK dividend rate on a preferred equity instrument).
Debt financing represents an obligation (liability) to pay back borrowed money plus interest to a lender. A lender does not receive ownership interest in a company when providing debt financing to a company. Debt is senior to all equity in the capital structure and would be paid out first in a liquidation scenario.
Debt financing is not commonly available to traditional startup businesses because these companies do not have a track record, do not have collateral, and do not have an established credit history for the business. Startups, by their nature, are riskier investments, often with negative cash flows for (at least) the first few years of their existence. At the earliest stages of the startup’s life, the company will not likely have the capacity, ability, or interest in having an obligation to use cash for servicing debt in the form of interest payments.
While debt financing is not the traditional source of capital for startups, it is a valuable tool for businesses to grow and sustain operations. Below are a few examples of various debt instruments which may be available to companies over their business lifecycle.
While debt instruments vary in the complexity of their features, they each result in the company receiving cash from a lender in exchange for an obligation to repay principal plus interest over time. The holder of the instrument does not receive ownership in the company.
While many may think of a debt instrument in terms of a bank loan in the context of small business, a conventional bank loan will often not be available to the startup. This is because banks look for a credit history, collateral, and financial performance metrics (i.e., positive EBITDA to service the debt) from the underlying issuer or borrower to determine credit worthiness and a borrowing rate. Startups rarely have any of these, and must look to other debt financing alternatives as a result.
Common types of debt instruments available to startups are:
- SBA Loan
- Convertible Debt
- Venture Debt
The Small Business Association (SBA) offers loans to startups through 3 core programs.
The SBA does not directly lend to borrowers, but rather sponsors lending programs through lending partners which includes banks, credit unions, and other financial intermediaries. According to the SBA site, the SBA reduces risk for lenders and makes it easier for lenders to access capital for riskier loans, which in turn makes it easier for small businesses to get loans.
The 3 core loan programs for small businesses are:
Each loan program has unique eligibility requirements, but broad requirements include:
- Be a for-profit business
- Do business in the United States
- Have invested equity
- Exhaust other financing options
Convertible Debt is a debt instrument that accrues interest over time and is convertible into equity shares of a company based on the terms of the instrument at closing. The convertible debt instrument provides the startup with cash needed to operate the company in exchange for the obligation to pay the lender back the principal plus accrued interest in the form of shares in the company in the future. This instrument will continue accruing interest as a debt instrument until it is converted, at which point it is treated as the other equity securities it converts into.
Venture Debt is similar in many ways to conventional debt financing except that it typically does not require collateral from the startup. These instruments are usually available to startups which have already raised multiple equity rounds and proven the business, but have not yet begun to generate positive cash flows.
Venture debt financing typically involves the startup re-paying the lender principal, interest and stock warrant “kickers“. As a result, the all-in interest rate of a venture debt instrument will usually be greater than that of an interest rate on a conventional loan. Like other debt instruments, venture debt instruments can include covenants which will result in some form of economic penalties to the company if breached.