There are many ways to raise capital for your startup… and many potential pitfalls. While the initial conversation may center on “how much do we need?”, startup companies should also take some time to discuss “how do we structure this financing?”. Your startup may have short-term or long-term needs, may desire long-term investment and involvement from VC investors, may or may not know the valuation of the company, etc. The answers to these types of questions may factor in to choosing which capital-raising method works best for you and your company.
Before you can determine what approach is right for you, it’s helpful to figure out what the different options are and how they work. The list below contains a brief description of the most common methods by which a company can raise capital.
- Equity. Issuing equity (also known as stock, shares, interests, or securities depending on the type of entity) in the company is one of the most common capital raising strategies and preferred by most investors and venture capitalists. An investor buys a certain amount of equity in the company, which means that investor now owns/controls a certain percentage of the business and is entitled to at least that percentage of the company’s value upon a sale or liquidation of the company, or more if the equity is “preferred” equity. Therefore, issuing equity usually dilutes the relative ownership of the founders from both a financial and control perspective. One important caveat: when a company issues equity, it must comply with federal and state securities laws – it is surprisingly simple to run afoul of these laws, and the burdensome disclosure requirements and fines that the SEC can impose as a result can be devastating to a new company.
- Debt. Much like the personal debt examples of a mortgage or student loans that we are all accustomed to, debt involves one party giving another money, and the recipient promising to pay it back at a point in the future, plus interest. The repayment of that fixed amount at a fixed maturity date, regardless of the level of the borrower’s earnings, means two things for a startup: One, debt might be a risky option if the company is not generating revenue, because the company is still obligated to pay back the debt plus interest upon the maturity date whether the company is doing well or not. Two, because the amount of repayment does not change with the relative success of the company, debt is not the high-risk high-reward type of investment that many venture capitalists or angel investors want to take. Debt is not without a very real benefit though: issuing debt does not affect ownership of the company. So debt can be a better option for a more established company that is able to prove its reliability (and ability to pay back the debt) and does not want to relinquish control.
- Convertible Note. This is a hybrid option between debt and equity: a convertible note is a debt instrument which allows the holder to convert it into equity upon specific triggering events– usually, a next round of financing or a sale of the company. Prior to conversion, a convertible note has the typical characteristics of debt: a principal balance, interest rate, repayment or maturity date, and priority ahead of equity holders in a liquidation. However, many startups can forget: a convertible note is no less a promissory note because of its potential ability to later convert; it is still a debt instrument which requires the debtor to pay back the amount of the note if no triggering event has occurred by the maturity date or the debt holder elects not to convert to equity. The conversion simply provides more than one possible method of repayment of the initial investment.
- SAFE: Simple Agreement (for) Future Equity. Very similar to a convertible note, a SAFE allows holders to receive shares upon a certain triggering event. Also similar to the convertible note, if the company dissolves while the SAFE is outstanding, the company pays the holder the amount of the holder’s investment, like a debt instrument. The key difference between the SAFE and a convertible note is that there is no maturity date or holder-triggered repayment of the SAFE – as long as a triggering event does not occur, the SAFE can remain outstanding indefinitely.
- Other. There are numerous other ways to raise capital (including Stock Appreciation Right/Phantom Stock) but they are less common and sometimes have unique requirements or are not particularly desirable to investors.
Raising capital is an exciting time for any startup, but it can be quite complex to figure out what is best for your company.