This is not legal or financial advice.
SAFEs, convertibles, revenue financing, oh my. The options for funding your growing business are constantly evolving. As lenders and investors become even more creative with the creation of new financial instruments, it is getting harder to understand what they all are and when to choose one over the other. We are going to break some of the most common into categories, and provide a little guidance on the various components of each.
There are two main options for financing your business: selling equity and issuing debt. Equity financing comes from selling a piece of your company to another party. Debt is generated when you take money from a lender with the expectation that you will pay them back their investment plus some fees and interest.
Other types include revenue financing, self financing through operations and factoring. Revenue financing is basically selling someone a slice of your future sales. They get paid back whenever you collect money from your customers. Self financing is the use of profits from your business to fuel growth. Factoring is the sale of receivables to another party who collects the payment from your customer.
The purpose of all of these is to either finance operations (working capital) or purchase more assets. The mix you choose should be determined by the company’s plans for deploying the money you take in (use of funds).
Equity
Selling equity is the same as bringing a new business partner into your company. As management, you will now have a duty to act in everyone’s best interest while operating the company, which can often be in conflict with your own personal interests. That duty is called a fiduciary duty and there are serious consequences for violating it. Another consideration is you can’t get your equity back if the person you sold it to will not sell it back. This is why it is paramount that you build a relationship with equity investors before taking their money.
The upside of equity, as opposed to debt for instance, is that you are not expected to pay the money back. Instead, your job is to deploy that money in a way that increases the overall value of the company for the shareholders. This can relieve some of the pressure associated with debt, as there is no formal timeline when that return has to be generated. Obviously the sooner the better, but there are very few business-ending consequences if it takes longer.
That said, here are some common forms of equity financing:
- Common stock - the word common in this sense just means that you are an owner of the commonly held assets of the company. Usually this stock does not come with any special rights around voting, liquidation preference or pro rata investment. Functionally, most new investors are going to want to invest in a different (see: preferred) class of stock, so this class is usually held primarily by insiders.
- Preferred stock - often investors want to create a new class of shares that have certain other rights attached to it. For instance, a preferred class of stock might stand in front of common shares in dividend distribution or minimum thresholds guaranteeing a certain return in the case of the business being acquired. This protects them and makes the investment more attractive from their perspective. The negotiation of these rights can often be more important than the share price, as they can severely reduce or eliminate the expected payout for common shareholders. When you raise equity as a private company, especially from venture capital firms, this is probably the most used structure.
- Simple Agreement for Future Equity (SAFE) - this isn’t equity per se, but it is a way to get funds in the door quickly without haggling over the value of the shares today. This is becoming more prevalent in early startup financing where it is hard to properly value the company’s equity. This agreement usually has a cap and a discount - meaning when the price of equity gets set in a later round, there is a maximum valuation plus a discount at which this instrument gets converted to equity. Early stage startups should consider this type of financing as it is easy to document and there are fewer moving parts to negotiate.
Debt
Unlike equity, debt does not confer everlasting ownership of your company to an outside party. However, there is often certain collateral pledged against the loan. In other words, if the company cannot pay back the debt, the lender can take possession of whichever assets were pledged to (or secured) the lender. In exchange for the money, the lender gets paid back their money (principal) with interest. In the event the company cannot pay its debt, the lenders can force the company into bankruptcy. During this process, they get paid out whatever funds are left in the company before any shareholders receive payment. This makes debt risky because you can’t miss payments or the company will be in serious jeopardy.
Here are some of the more common types of debt:
- Line of credit - this is a pool of funds that your lender authorizes you to draw down or spend as needed to finance your business. There is a limited amount you can use in any given period and repayment is expected in a short amount of time. The classic example of this would be a corporate credit card. You might be approved for a $50,000 line of credit, which you can spend as you see fit. However, the balance comes due at the end of the month and any unpaid amount gets charged a high interest rate. This type of financing is good for very short term cash needs. For example, if you need supplies to fulfill a customer order. It is not recommended to use these lines to fund longer term purchases like a business vehicle, for instance, because of the high interest rate.
- Loans - there are many types of loans, but a few components are common - interest rate, term, amortization and covenants. The interest rate is the rate charged by the lender as a fee for using the money. The term is the length of the loan agreement period, the amortization is the length of time the payments are spread across, and the covenants are restrictions and promises about the use of funds and company activity while the loan is outstanding. If you have a long-term project or a large asset that needs to be financed, this type of financing is usually appropriate.
- Convertible Notes - sometimes the lender wants to be able to convert the amount of the loan plus any outstanding interest into equity of the company. In these cases, a special kind of agreement is drafted to add language around how, when and at what price that conversion happens. In addition to SAFEs, this is a common method of financing early stage startups and is used by most of the premier venture accelerators.
Others
Finance people are nothing if not creative. We are always thinking up new types of instruments that can be used to finance a business.
Here are two types of financing that are neither debt or equity:
- Revenue financing - this is simply selling a share of your future income to a third-party. The financier will give the company money, then watch your bank account and draft their repayment as the funds flow in. While this isn’t debt per se, this type of financing is usually very expensive. You can easily pay back double the amount you were given over time. In my opinion, there are better ways to finance your business.
- Factoring - this functions a lot like revenue financing except you are actually selling the third-party your receivable related to a customer sale. Technically this is an asset sale. The catch is that they will buy it for less than it is worth (i.e. at a discount). Unless you have a really high margin business, this is usually a very hard cycle to stop once you start.
Hopefully this provided some clarity on the multitude of options to finance your business. Financial instruments can get complicated quickly, so be sure to speak with your financial or legal advisors before committing to anything.
For answers to questions you have about this or related topics, schedule your free consultation today.
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