In the early stages of a start-up, founders typically seek to bootstrap (i.e. self-fund) their operations in order to preserve value through their hard work and expertise. At some stage, most start-ups will need a cash infusion to grow their business and take it to profitability. That’s where investors come in.
Before raising capital, it is important to understand the most common forms of seed investments: equity and convertible debt. Each form of funding has its own pros and cons, and is a better fit for certain situations than others.
Equity represents an ownership interest in the company. While equity doesn’t provide as much certainty of repayment as compared to a loan, it gives the investor a greater chance of participating in the upside in a profitable company or a future sale.
The size of an investor’s shareholding in the company will be negotiated based on the amount of the investment and the agreed valuation of the company. It generally involves a compromise between the investor’s eagerness to invest in the company and the founder’s desperation to raise funds.
Equity typically takes the form of ordinary shares or preference shares.
Ordinary shares have various rights attached to them (such as voting and dividend rights), but they usually rank behind other securities in terms of priority.
Preference shares differ from ordinary shares because of the additional rights (preferences) that attach to them. They typically confer on the investor:
- A liquidation preference, which entitles the investor to recover an additional amount (ahead of all ordinary shareholders) in a liquidation of the company; and
- An entitlement to receive dividends in priority to the holders of ordinary shares; and
- An ability to convert the shares into ordinary shares on a future exit.
Preference shares are typically used for more substantial investments as their terms are generally complicated and heavily negotiated.
A convertible debt instrument involves the company borrowing money from an investor in the expectation that the debt will convert into equity in the company in the future (such as after a capital raising or a sale event). It is essentially a mix of equity and debt.
Here is a basic example of how convertible notes work:
- An investor invests $200,000 in a start-up by way of a convertible note.
- The terms of the convertible note are a 20% discount and automatic conversion after a future capital raising exceeding $1 million.
- When the next capital raising occurs at a $2 million valuation, the convertible note will automatically convert into equity.
Let’s assume the shares are issued for $1 per share. As a 20% discount applies, the investor can use their $200,000 investment to purchase shares in the next funding round at the discounted rate of $0.80 per share. This gives the initial investor $250,000 worth of shares for the price of $200,000 (representing a 25% return).
Convertible debt has become a popular form of seed funding for a number of reasons.
- Valuation: Issuing equity requires you to value your company. This can be a difficult exercise for a company in its early stages. A key advantage of a convertible note is that it doesn’t require the company to be valued until a larger equity round is raised.
- Cost and speed: Convertible debt is simpler to document than equity financings. This means that they are generally less expensive and that funding rounds can be closed more quickly than equity raisings.
- Control: Many founders are (naturally) concerned about relinquishing control of their company. Holders of convertible notes typically receive minimal control over the company (for instance, no veto rights or director appointment rights). This is especially helpful for start-ups wishing to undertake a further capital raising without investor interference.
As early stage investment is risky, investors often sweeten their deal by asking for a valuation cap. A valuation cap limits the price at which convertible notes will convert into equity. It is used to protect early investors in case the company’s value skyrockets in the next funding round. For instance, if the valuation cap is $1 million, but the company’s valuation at the next funding round is $1.5 million, then the amount invested will convert into equity at the $1 million valuation cap.
Every situation calls for a different type of investment structure. It is important to understand the subtleties of the various structures and balance the particular needs of the company against the risks and rewards available to the investor.