How Am I Going to Pay for This? A Startup and Growth Capital Primer for Issuers and Investors
One of the most pressing questions on every would-be entrepreneur’s mind is how to fund their business venture. Like it or not, it’s hard to make money if you don’t have any. Fortunately, as investor interest in startup businesses has grown over the past several decades, so too have the financing options available to those businesses. This article provides an overview of the common financing structures available to issuers and investors of growth capital at various stages of an emerging business’s life cycle.
The seed stage
The first stage of financing a startup business is typically referred to as the “seed” stage. Most commonly, such financing will originate from friends and family of the founder(s). Less commonly, such funding may come from an “angel investor” – typically a wealthy individual who invests in startup companies on a part-time basis and contributes not only funds but also expertise to the startup business.
Seed stage investments take many forms. The simplest is a direct investment into common stock – the same security held by the startup company’s founders. An investment in common stock is usually accompanied by the right to vote on matters presented to stockholders for approval, the right to receive dividends (although they are unlikely to be declared by a startup company), and the right to receive a proportionate share of the company’s assets upon liquidation, after the prior satisfaction of the company’s debts. Investments in common stock of a startup company are highly illiquid, meaning that they cannot be readily resold on an open market and do not carry with them many of the benefits associated with other investment instruments discussed in this article. Common stockholders can and typically will find their equity stakes diluted during the course of a startup’s growth. From a founder’s perspective, issuing common stock to outside investors may threaten the founder’s control over the company, especially as the founder’s own equity gets diluted as a result of subsequent financing rounds. Investments in common stock are, however, relatively simple to document and understand, and may be viewed by issuers and investors as a “default” option during the earliest stages of a startup’s life cycle.
Experienced investors will often prefer to invest seed capital through convertible notes. Convertible notes are debt securities that contemplate repayment of principal upon maturity, accrue interest at a modest, fixed rate and are convertible into equity (often at the option of the investor) upon the occurrence of a subsequent financing event, the sale of the borrower’s business or maturity. By using a debt instrument versus the direct purchase of the company’s equity, an investor benefits from sitting in priority to equity holders in the event the business should be unsuccessful and needs to liquidate its assets.
In calculating the amount of equity for which the outstanding indebtedness will convert, convertible notes usually offer the investor favorable conversion ratios. The investor is therefore likely to see a more favorable return on his or her investment from conversion into equity rather than from the repayment of principal and interest on the note. For this reason, the conversion formula and mechanics set forth in a convertible note are typically far more important to both issuers and investors than the interest rate, maturity date and other traditional debt terms.
In addition, several alternative financing instruments have emerged in recent years that, while not yet widely adopted, have the potential to simplify and streamline the seed financing process. Perhaps the most popular of these instruments is the “simple agreement for future equity” or “SAFE,” created by the influential startup accelerator, Y Combinator. SAFEs share many features with convertible notes, including similar conversion triggers, conversion prices and priority in the event of a liquidation. However, unlike traditional debt instruments, SAFEs do not include a maturity date and do not accrue interest.
The lack of a maturity date and interest accrual makes SAFEs a very attractive financing option for startup founders who are reluctant to put debt on their books or are fearful of their ability to repay that debt should their loan reach its maturity date before the startup has raised another round of financing. For investors, however, use of a SAFE may carry more risk than a traditional convertible note. Because SAFEs lack a maturity date, investors lose leverage they would have with a convertible note because they could demand repayment of their investment upon maturity and, theoretically, bankrupt the company.
Furthermore, investment through a SAFE presupposes that the startup company will engage in subsequent financing rounds. If the company instead grows organically without ever needing to raise additional equity capital, it is possible that a conversion event is never triggered and the SAFE holder is left in limbo until the company is eventually sold or liquidated. For these reasons, SAFEs are generally viewed as “issuer-friendly” investment instruments and may only be a realistic financing avenue for the hottest startups.
Early stage and growth financing
After a startup has proven that it has a viable business concept, the company may seek larger sums of capital from venture capital funds and other sophisticated investors to fuel its growth. Such financings are typically referred to as “rounds” and are often delineated by letters and numbers representing each round’s “place” in the startup’s life cycle. Naming a financing round involves considerations beyond the scope of this article. For example, a startup may not wish to signal to the marketplace that it has needed to raise too much capital too quickly. However, the “classic” rounds of financing are typically labeled “Series A,” “Series B” and so forth, with smaller rounds falling in between significant milestones often labeled with numbers such as “Series A-2.”
Regardless of nomenclature, these growth rounds are usually structured as investments in preferred stock, since early-stage companies are typically not good candidates for commercial bank loans, and venture capital investors are ordinarily seeking returns on their investments that traditional debt structures cannot offer.
The first such round, which we will term a “Series A” financing, is customarily documented through a stock purchase agreement, an amendment and restatement of the company’s certificate of incorporation, and related ancillary agreements providing for various investor rights and protections. While exact terms will vary from deal to deal, Series A financings typically include the following terms:
- Liquidation preference. Series A investors are usually granted a liquidation preference to ensure that, in the event the company is liquidated, they will receive at least their invested capital before any common stockholders receive payments.
- Upon issuance, each share of Series A preferred stock is convertible into one share of common stock at the stockholder’s option at any time. This conversion mechanism is used to calculate the proceeds payable to the preferred stockholders in the event of a successful liquidity event, i.e., a liquidity event in which the Series A stockholders receive proceeds greater than their invested capital, as well as to protect stockholders against dilution.
- Anti-dilution protection. Series A investors typically receive protections against future, dilutive equity issuances. These protections are usually triggered only if the company later issues equity at a price below the price paid for the Series A shares – commonly referred to as a “down round.” In the event the company engages in a down round, the conversion ratio applicable to the Series A preferred stock is adjusted in accordance with a predetermined formula such that each share of preferred stock will convert into more than one share of common stock.
- Minority stockholder protections. Series A investors are usually granted “veto” powers over certain company actions. Where there is more than one Series A investor, such decisions are typically made as a group by majority vote. While the specific list of veto rights is usually highly negotiated, it often includes the issuance of additional equity, declaration or payment of dividends, amendment of the company’s charter documents, and entering into certain major corporate transactions.
- Board seats. Series A investors are usually entitled to one or more seats on the company’s board of directors. Where multiple investors participate in the round, typically the largest investor will receive the board seat. In addition, the Series A director will often receive certain veto rights over important board decisions.
- Preemptive rights and rights of first refusal. Series A investors usually receive a “preemptive” right to purchase, on a pro rata basis, any new equity securities offered by the company. They also are typically granted a “right of first refusal” in the event that a company founder or other large common stockholder desires to sell their shares.
- Co-sale rights. In the event that one or more common stockholders agree to sell to a third party a significant amount of the company’s outstanding common stock, Series A investors usually have the right to sell a proportionate amount of their preferred stock as part of the same transaction.
- Most Series A financings provide that stockholders may not be paid dividends on their common stock unless the preferred stock is paid the same proportionate dividend.
This list of terms is far from exhaustive, but should provide a good idea of the complexity of a Series A financing. Subsequent rounds of financing, while structured in much the same manner, are accompanied by the additional complexity of determining the rights and privileges of different series of preferred stock vis à vis each other. Subsequent financing rounds may become increasingly difficult to negotiate, as the company’s existing investors will usually want to participate in the negotiations. If new investors desire veto rights or other protections that are greater than those granted to existing preferred stockholders, those existing stockholders will often demand to receive the same rights.
Later-stage investors will typically seek more control over the company’s governance, particularly as it pertains to any liquidity event. This desire for control may be driven largely by the investors’ desire to ensure that they receive a certain return on their investment prior to their exit. Such control is usually accomplished by a combination of board seats and veto rights.
To help them realize some value for their (presumably) years of hard work and low pay, it is not uncommon for company founders and other early employees to be permitted to sell a portion of their stock as part of a later financing round.
The proliferation of venture capital firms and technology startups, and the incredible dollar amounts attached to some of their deals, has brought an unprecedented level of attention to the world of startup financing. Despite popular belief, however, startup financing is by no means “one size fits all.” Investment terms should be custom tailored to the needs of both the issuer and investor, and all parties should be wary of the ill effects that a poorly planned and documented transaction can have on a business’s growth and returns.
Nick Rueter is a partner in SGR’s Corporate Practice. He represents clients in corporate and transactional matters, including mergers and acquisitions, joint ventures, venture capital and private equity transactions, emerging company issues, fund formations, private placements, and franchise law.