How to Raise Capital for Your Startup (and the Legal Considerations You Should Know About)
How to Raise Capital for Your Startup
Raising capital for your startup (or if you are an entertainment industry entrepreneur - your creative project, film, production, etc.) can be a daunting process, and understanding the legal considerations of different funding types is essential in order to make the right decision. Two common methods of raising capital are convertible debt and equity funding; both have their benefits and drawbacks.
As you begin your planning to raise capital for your startup you will find that the options are endless. You'll hear advice like "friends and family are best," or "join a startup incubator." One of the main options you might find is convertible notes (also known as convertible debt). When it comes to convertible debt, it is basically a loan that converts into equity at a predetermined price in the future. This type of funding gives companies more time to establish themselves before giving up equity in exchange for investment. The downside to this method is that it can be difficult to predict how much equity will be given up when the debt converts, as it often depends on the company's performance over a certain period of time.
Equity funding, on the other hand, requires giving up a portion of ownership immediately in exchange for investors’ money. While this means giving away some control over the company’s direction and decisions, it also means not being tied into any repayment obligations. However, there are tax considerations when equity funding as well.
When making the decision between convertible debt and equity funding, it is important to consider the financial and legal ramifications of both. It is helpful to speak with a tax or legal professional who is knowledgeable about the different types of funding and their implications. Additionally, consulting with experienced investors who have gone through the process can be beneficial in understanding which method is best for your company.
Ultimately, it is essential to conduct thorough research and consult with experts in order to make an informed decision about the type of funding that is best for your startup. By understanding the different types of funding and their implications, you can make an informed decision that is in the best interest of your company.
In this article, we will take a look at the pros and cons of convertible debt vs equity funding for startups so you can make an informed decision about which route is best for your business needs.
Types of Securities Offerings
There are two primary types of securities offerings that a startup can use to raise capital: private offerings and public offerings. Private offerings are typically only available to accredited investors, while public offerings are available to the general public.
Private offerings
Private offerings are a type of securities offering in which a company sells securities to a small group of investors. These investors are typically accredited, which means they meet certain financial requirements that make them eligible to invest in private offerings. Private offerings are often less regulated than public offerings and may require less disclosure.
Public offerings
Public offerings, on the other hand, involve selling securities to the general public through a registered exchange or other offering mechanism. Public offerings are subject to more rigorous regulatory requirements, such as the Securities Act of 1933 and the Securities Exchange Act of 1934. As a result, they require extensive disclosure and reporting to the Securities and Exchange Commission (SEC).
The decision to use a private or public offering depends on a variety of factors, including the amount of capital needed, the desired level of regulatory scrutiny, and the target investor audience. Private offerings may be more suitable for smaller capital raises or for companies seeking to limit their regulatory obligations, while public offerings may be better suited for larger capital raises or for companies seeking broader exposure to the investing public.
How to Raise Capital as a Startup
Raising capital for your startup can be daunting and overwhelming, but understanding the different financing methods available will help you to make the best decision for your business. There are two main types of funding: convertible debt and equity. Let’s look at the pros and cons of each so you can make an informed decision when it comes to choosing the right type of financing for your startup.
Convertible Debt
Convertible debt is a type of loan that helps startups acquire capital quickly and easily with fewer legal regulations. These loans can be converted into preferred shares at a predetermined rate, usually when more traditional means of financing become available. The main pro here is that the terms are usually less stringent than those of other types of loans. On the downside, dilution of ownership can occur if a loan isn't converted before additional funding is raised. Additionally, there have been reports of convertible debt yielding higher interest rates than traditional loans or credit cards.
Equity Funding
Equity funding involves giving investors a stake in your business in exchange for capital. It’s often considered ideal for startups because it eliminates loan payments and allows investors to profit from their stake in the company as it grows in value. However, this kind of funding also means giving up part ownership in your business which could dilute your influence over future decisions. Additionally, equity funding requires more paperwork and legal considerations relative to convertible debt financing—so you’ll want to ensure you’re well-versed on all applicable laws before agreeing to any investment terms.
What Is Convertible Debt and How Does It Work?
Convertible debt is a type of financing for startups and small businesses. It is a loan that can be converted into equity in the future, at the discretion of either the investor or the company. This means that instead of taking a payout from profits, the investor can convert their loan into stock in the company.
The benefits of this approach for investors include:
A good return on investment - Investors are paid interest on the loan until it is converted to equity.
Flexibility - Investors are not immediately tied to a company's success or failure and can choose when to convert their loan into stock.
Lower cost and faster access to capital - Since convertible debt is a loan and not an investment, startups can raise capital more quickly and with lower costs than through traditional equity funding.
For startups, this method presents advantages like:
Lower risk of dilution - Convertible debt eliminates risk of immediately diluting shares since the lender will only convert their loan after a predetermined milestone.
Reduced paperwork and legal fees - With convertible debt, companies avoid paperwork associated with traditional fundraising methods since lenders do not need Certain rights associated with traditional investments.
Attractive options to early-stage companies - Convertible debt provides companies with access to capital from non-institutional investors who may be more attractive than venture capitalists.
Pros and Cons of Convertible Debt Funding
When it comes to raising capital as a startup, one of the most commonly pursued options is Convertible Debt Funding. It's popular because it allows entrepreneurs to collect capital quickly, all while preserving their control over the business. However, there are certain pros and cons of this type of funding that you should be aware of before deciding if it's right for you.
Pros:
Flexible - Convertible Debt is more flexible than traditional debt, as it does not need to be repaid at a set time or with interest payments. Instead, repayment can be adjusted when a company seeks additional funds from outside investors or when fundraising from them in the future.
Cost Effective - Convertible Debt funding can also be more cost effective than other forms of financing since debt holders do not require interest payments until the loan is converted into equity.
Accessible - Since convertible debt does not require repayment until funds are raised from outside investors, entrepreneurs typically have more access to this form of financing compared to traditional debt financing.
Cons:
Risky - An entrepreneur taking on convertible debt takes on the risk associated with relying on outside investors for funding, which means there may be a significant reduction in ownership control if their terms cannot be met when fundraising from them in the future.
Unpredictable - Since there is no fixed timeline or rate for repayment of convertible debt, startup owners may have difficulty predicting how much money they will owe at any given time and what their return on investment will ultimately look like.
Lower Conversion Rates - Compared to other forms of financing such as Angel Investment or Venture Capital, convertible debt has lower conversion rates to equity since the loan must generally be repaid
What Is a Safe Convertible Note?
A Convertible Note—or Safe Note—is a hybrid of debt and equity. It acts as a loan until the startup raises another round of capital or is acquired, at which point the loan converts into equity in the company.
Safe notes are designed to bridge the gap between early stage funding (seed money) and a Series A round, minimizing legal fees and paperwork for both parties by providing a quick and efficient way to get funds to the startup.
However, this type of financing comes with some legal considerations that must be taken into account. Here are some factors you should consider before opting for convertible debt:
Terms of conversion: The terms of conversion must be clearly stated in any convertible note agreement, including when it will convert to equity, how much equity it will convert to and what level of valuation is necessary for conversion.
Valuation cap: A valuation cap protects investors by limiting how much equity they would receive if the company is sold for a much higher value than expected—ensuring that they don’t lose out just because there was an unexpected surge in the company’s value.
Interest rate: Convertible notes usually offer no interest or minimal interest on their loans, usually only enough to cover administrative costs associated with the loan.
Dilution protection: Dilution protection ensures that if another financing round adds more shares to dilute investors’ holdings, their stake in the company will increase proportionally so they don’t lose out on their investment.
Understanding a Note Issuance
As a startup, you may choose to raise capital via convertible debt rather than equity funding. A convertible note is similar to a loan, but has some key differences. Specifically, it is an agreement between you and the investor that provides them with some security – the note – which can later be converted into equity.
Before signing off on a note issuance, there are a few key things you should consider:
Documenting Terms
A note issuance should include terms around interest rate and conversion rate that are clearly stated in the document. This ensures that all parties understand the agreement and its implications upon conversion.
Timing of Conversion
The timing of when the investor will convert their note into equity can significantly affect the overall capitalization of your company. It's important to negotiate a timeline that works for both parties and properly documents it in the agreement.
Right of First Refusal
When negotiating a convertible debt financing round, make sure to include clauses outlining you or your investors' rights in case of future funding rounds. This will help ensure that existing investors are not diluted as you continue to raise money for your business venture.
Convertible Debt vs Equity - Who Wins?
The decision between convertible debt vs. equity as a startup’s means of raising capital is ultimately dependent on the amount of capital needed and the desired timeline of achieving a return.
Advantages of Convertible Debt
Convertible debt has several advantages for startups looking for a shorter term loan option. These include:
Quicker to secure than equity funding
Investors receive a return in the form of interest payments
Flexibility to negotiate conversion terms
Lower legal costs associated with setting up the loan agreement
More control over the future of your company, as you do not have to give away ownership stakes in exchange for funds
Advantages of Equity Funding
Equity funding, meanwhile, provides more stability than debt as it can be used to cover operational costs over an extended period of time. The advantages include:
No repayment or interest payments are required
You can access larger sums of money quickly and without having to provide collateral
Investors receive equity in exchange for their investment, leading to potential future payouts when it comes time to exit
You retain full ownership over your company without needing to worry about repayment deadlines
At the end of the day, understanding both convertible debt vs equity options is key if you want to make sure you’re making an informed decision that aligns with your specific needs as a startup business owner.
Legal Considerations for Startups Raising Capital
For startups considering raising capital, it's important to understand the legal considerations of each type of funding they choose.
Convertible Debt
When raising capital through convertible debt, startups need to make sure that their loan terms are structured in such a way as to protect them in the event of a down round. Specifically, they should make sure that the conversion price is no lower than the lowest price in subsequent rounds of financing.
Equity Funding
When raising capital through equity funding, startups need to ensure that their shareholders have the right to vote on major decisions affecting the company. This will ensure that investors maintain some level of control and input over how funds are used and what strategic direction is taken by the company going forward.
Startups should also be aware of any potential tax implications associated with issuing equity or debt securities before embarking on a fundraising round. It can be helpful to consult with a qualified attorney or accountant early in the process in order to ensure compliance with all applicable laws and regulations.
Accredited Investors
An accredited investor is an individual or entity that meets specific financial criteria, such as having a net worth of at least $1 million or earning an annual income of $200,000. Accredited investors are allowed to participate in private offerings because they are presumed to have the knowledge and experience necessary to understand the risks involved.
Essentially, an accredited investor is an individual or entity that meets certain financial requirements. The Securities and Exchange Commission (SEC) defines an accredited investor as someone who has:
A net worth of at least $1 million (excluding the value of their primary residence)
An annual income of at least $200,000 (or $300,000 if they are married and filing jointly) for the past two years, with the expectation of earning a similar income in the current year.
Entities can also be considered accredited investors if they meet certain criteria, such as having over $5 million in assets or being a venture capital fund.
Why are accredited investors allowed to participate in private offerings? Essentially, the idea is that these investors have the knowledge and experience necessary to understand the risks involved in investing in a startup. By contrast, the general public may not be as well-equipped to assess the potential risks and rewards of investing in a private offering.
It's worth noting that there are some risks associated with investing in private offerings, even for accredited investors. Private offerings are typically less regulated than public offerings, which means there may be less information available about the company and its financials. Additionally, private offerings may be less liquid than public offerings, meaning it may be harder to sell your securities if you need to raise cash quickly.
So, why might you choose to pursue a private offering? For starters, it can be a good way to raise capital without having to go through the more complex and time-consuming process of a public offering. Additionally, by limiting your investor pool to accredited investors, you may be able to build stronger relationships with these individuals and benefit from their expertise and connections.
The Convertible Note Term Sheet
The convertible note term sheet is an important document in the early-stage financing process as it outlines the key terms and conditions of the convertible note, such as interest rate, maturity date, conversion discount, and anti-dilution protection.
When considering a convertible note term sheet, startups should review the following carefully:
Interest Rate: This is the rate at which borrowers will pay interest on their convertible debt. This rate should be determined by prevailing market rates.
Maturity Date: This is the date on which the convertible note will mature and must be repaid in full.
Conversion Discount: This is a discount that investors receive when they convert their debt into equity. The amount of this discount will depend on market conditions and investor preference.
Anti-Dilution Protection: This is a clause in the term sheet that helps protect investors from dilution of their existing equity position when additional shares are issued at a lower price during future rounds of financing.
By understanding these key terms and negotiating them with potential investors up front, startups can ensure that their financing arrangements are fair for all parties involved.
Important Additional Terminology for Raising Capital (Terms the Entrepreneur Needs to Know)
Securities Laws
When it comes to raising capital, startups must comply with federal and state securities laws. The Securities Act of 1933 regulates the offer and sale of securities in the United States, and startups must file certain forms with the Securities and Exchange Commission (SEC) before offering securities.
Offering Documents
Offering documents are legal documents that provide information to potential investors about the securities being offered, the risks involved, and the terms of the investment. These documents include a private placement memorandum (PPM) for private offerings and a prospectus for public offerings.
Due Diligence
Before investing in a startup, investors will conduct their own due diligence to assess the risks and potential returns of the investment. Startups must also conduct due diligence on potential investors to ensure they are accredited and to avoid any potential legal issues.
Crowdfunding
Crowdfunding is a relatively new way for startups to raise capital through online platforms, but it is also subject to securities laws. Startups must comply with the SEC's crowdfunding rules, which limit the amount that can be raised and the types of investors who can participate.
Convertible Notes and SAFEs
Convertible notes and Simple Agreement for Future Equity (SAFE) are popular ways for startups to raise capital without valuing the company. These instruments allow investors to convert their investment into equity at a later date when the company is valued.
Intellectual Property
Startups must also protect their intellectual property when raising capital. Investors will want to ensure that the company has ownership of any patents, trademarks, or copyrights that are essential to the business.
Legal Counsel (Working with a startup lawyer)
Raising capital can be a complex and challenging process, and startups should seek legal counsel to ensure compliance with securities laws and protect their interests. An experienced startup attorney can help startups navigate the legal landscape and avoid any potential legal pitfalls. A great lawyer can help you navigate the complexities of securities laws, draft legal documents, and ensure you're complying with regulations, all while helping you to be more appealing to venture capitalists and angel investors.
Raising capital is an essential part of starting and growing a business, but it is also a complex process that requires careful consideration of legal considerations. As a startup, it's crucial to understand the securities laws, types of offerings, and investor due diligence required to raise capital successfully. By seeking legal counsel and understanding the legal considerations involved, startups can protect their interests and ensure a successful fundraising campaign.
If you're considering raising capital (particularly through a private offering), it's important to work with experienced securities lawyers to ensure that you're in compliance with all relevant laws and regulations. At our law firm, we have a deep understanding of the securities landscape and can help guide you through the process of raising capital for your startup. Contact us to speak with an attorney about your company and how we can help you raise capital.
What to Do With This Information
It's important to know the legal and financial considerations of choosing convertible notes over equity when raising capital for your startup. Convertible debt allows for less dilution and has a simpler term sheet, but you may be taking on debt with no promise of repayment when the company exits. Equity gives founders more control, but comes with a more complex agreement.
The decision can come down to several factors, including the size of the round, the goal of the investor, the funds needed and an assessment of the company’s future. Understanding the ins and outs of both funding options can help founders make the right decision when it comes to raising capital that best fits their needs.
You should have an experienced startup attorney helping you through this process. Contact us for help today.