Entrepreneurs are not always aware of the various financing structures that may be available to them when raising new capital to finance their growth. And, even if they are, they are not always sure what fair terms look like when receiving term sheets from investors. So, I solicited the help of my good colleague, Michael Gray, a Partner at Neal, Gerber & Eisenberg (www.ngelaw.com), and one of the best startup/venture lawyers in Chicago, to help me provide you with a high-level education on your options here. Michael clearly has his finger on the “market pulse” given his large base of angel and venture backed clients as well as his representation of venture capital firms. In this lesson we will explore the plusses and minuses of equity vs. convertible debt vs. venture debt, for your consideration. Please note that there are many subtleties to each of the securities discussed below and this does not address many of them, but is meant to give a very broad overview.
EQUITY
Issuing stock in your company is the route most entrepreneurs
pursue, especially for growth companies where cash flow is difficult to
predict, hence making it tough to forecast repaying debts. Equity is typically secured from angel
investors or venture capital firms.
Representative Terms: A typical Series A (first institutional
round) investor is looking for 25% to 35% of the company, in exchange for its
investment. So, if you are worth $1MM
pre-money, an investor would likely give you $500K for a 33% stake, as an
example. Most professional investors
will be seeking equity in the form of preferred stock, not common stock, where
they get a 6% to 8% interest and a liquidation preference of 1x their money
back before the common shareholders begin to participate in any sale proceeds
for the business. There are number of
types of preferred – including participating preferred, where investors “double
dip” on their interest and liquidation preference and also get their equity
upside pro rata with common, however, if this structure is used there is
frequently a limit of 2 to 4 times the liquidation preference before the
participating feature goes away. The
other type of preferred is straight convertible preferred where an investor
will get their 6 to 8% interest rate plus money back or they can convert and
get the equity upside of their stock pro rata with common. The security will include some form of
anti-dilution protection for the investor, typically a weighted-average rachet
in the event of a subsequent financing at a lower valuation. The investor will also be looking for
protective provisions, in terms of their rights as a shareholder to block certain
major actions (e.g. change of control, modification of the board size, changing
the charter so as to adversely affect their security, etc). Typically all employees will be required to
enter into invention assignment, non-disclosure, non-solicitation and
non-compete agreements. In addition, an
investor may ask the founder to vest some portion of their shares, in case they
need to make an executive change or if the founder quits. As an example, a founder may be asked to vest
50% of their ownership over a 2-3 year period, a pro rata portion “earned” each
month.
Advantages: Does not have to be repaid, like debt
does. Gives certainty of valuation for
your company which can also be a disadvantage if the value is very low.
Disadvantages: The most complex to structure (highest legal
bills, longest time to close). Usually
involves giving some level of board control to investors.
CONVERTIBLE DEBT
For situations where you do not want to set an equity
valuation (to not impede subsequent financings from other investors), or you
simply want the option of potentially paying back the cash, for a period of
time prior to taking in permanent equity capital, a convertible note is the way
to go. A convertible note is a hybrid,
part debt and part equity, where it functions as debt, until some point in the
future, when it may convert to equity at some predefined terms. Convertible debt is typically secured from
the same angel investors and venture capitalists that fund equity deals and is
usually used for smaller rounds of financing at the early stages of a company’s
life.
Representative Terms: A convertible note typical carries an
interest rate of 4%-8% per year, which is usually paid “in kind” (grow the
principal each month, not paid as cash interest). The note will typically convert into equity
in the company’s next financing, typically at a 15%-20% discount to the
valuation realized in a subsequent round or with warrant coverage of 15 to
20%. The discount can be as low as a 0%
discount and as high as a 50% discount, depending on the situation. The conversion valuation of the company is
not fixed, however, investors often will negotiate a cap on the highest
valuation their loan may be converted at regardless of the price on the next
round. Being uncapped is the best
position for the entrepreneur, but cannot always be achieved in the
negotiation. The term of the convertible note can be as
short as 6 months or as long as 2 years, depending on the needs of the company
or the investor. If no following
investment round is achieved during the term, the note can either auto-convert
into equity at some preset terms, or be required to be repaid in cash at such
time. The latter potentially being a gun
to your head that could force you to sell the business at a distressed price to
repay the loan. So, shoot for the
former, where you can.
Advantages: Much quicker and cheaper than issuing equity,
both for legal bills (can close in weeks, not months) and ownership dilution
(deferred until down the road and you can use the note proceeds to increase the
value of your company). It leaves
valuation flexible in order to meet the needs of subsequent investors. Interest payments do not typically need to be
paid in cash each month.
Disadvantages: You have a limited time frame before it needs
to be repaid, or convert into equity.
BANK DEBT
For startups with an existing product/track record or
existing or future assets to secure a loan, debt is another option to
consider. Bank debt is a senior
secured loan that sits on top of the pile, in terms of liquidation preference
(repaid before all other debt or equity holders). Bank debt for early stage companies is typically issued by more
aggressive bank lenders that understand the risks of startups, like Silicon Valley Bank, Square 1 and Private Bank.
Representative Terms: The note will most likely be secured by 100%
of the assets of the business, and the lender will typically lend 25%-75% of
the fair market value of assets, depending on the nature of the assets (e.g.,
ease of liquidating) and the stability of your business (e.g., consistent
performance over last couple quarters).
The lender will also most likely require that cash collateral be posted
or the executives to personally guarantee the loan, in the event the company
cannot repay it. The note typically
comes with a 6 to 18 month term, and carries a monthly cash-paid interest rate
in the range of prime plus 2%-4% per year.
There are often, but not always, warrants issued to the lender in these
types of transactions.
Advantages: The least dilutive to your ownership,
allowing you to keep 100% control and economic upside.
Disadvantages: Do not take this on if you do not have 100%
visibility into repaying the loan, as the bank can force you to liquidate the
company to recoup their loan, forcing the company (or yourself as guarantor)
into liquidation or bankruptcy. Interest
payments needs to be paid in cash each month.
Be sure to to re-read Lesson #4 on How
to Raise Capital for Your Startup, Lesson #32 on How
to Value Your Startup, and Lesson #56 on Frequent
Legal Questions of a Startup, for more details as it relates to this topic.
There are many “variations to a theme” as it relates to
investment structures and the above just touches on the big themes, so be sure
to solicit the advice of a lawyer who knows these deals well, like Michael, to
help you navigate through these complex options. For additional questions from here, Michael
can be reached at 312-269-8086 or mgray@ngelaw.com.
For future posts, please follow me at:www.twitter.com/georgedeeb
Popular (All Time)
Popular (30) Days
Tags
