Financing Structures to Consider
1. Debt
Debt is simple: Investor gives you money, and you promise to give it back at some point in the future.
Of course, the investor isn’t giving money away for free. They want a return. That return typically comes in the way of interest on the debt amount.
The investor may also want to protect their investment and reduce their risk by imposing certain restrictions on you. For example, they may secure the debt against assets of the business. That means, if you default on the debt obligations (i.e. you don’t pay it back when you’re supposed to), the investor can take the business assets from you.
Debt can also get creative with repayments structured through royalties and other custom features.
Warning:
A balance sheet with debt loads can scare off future investors if you don’t have the revenue yet to service those debt obligations.
2. Equity / Shares
Equity is also simple: Investor gives you money, and you give the investor ownership (represented by shares / equity) in your corporation.
The biggest challenge for most entrepreneurs in offering shares, is determining the valuation of your corporation. In order to give shares, you must have a valuation. The valuation is used to determine the price for each share you are selling to your investor. While this is most challenging at the pre-revenue stage of a business, the truth is: the valuation question is a challenge at all stages of a business’ life. To sell shares though, it is a challenge you must overcome.
There are typically two kinds of shares considered for an equity financing:
Common Shares - This is the simpler route to go. It’s the same class of shares as held by the founders, without any special features to be negotiated.
Preferred Shares - This is the more complicated route to go. Preferred Shares are a separate class that has attached to it special rights that exceed those of the other classes of shares. These special rights are negotiated by the investor.
Preferred Share financings can be expected with institutional investors / venture capital firms, regardless of the size of cheque they’re writing. If you’re raising capital from friends & family or angel investors, you are likely able to get away with Common Share financings instead, as long as the aggregate funds raised isn’t too high (typically things shift into Preferred Share territory once the financing is around the $750k mark).
3. Convertibles
Ok, so you don’t want debt. And you’re not ready to set a valuation. Are there alternatives?
There are two types of convertibles often used as alternatives to debt and equity financing:
Convertible Debt - Investor gives you money, and you promise to give it back at some point in the future. But! If you do an equity financing prior to that future date, then their loan will convert into shares on the terms of that equity financing. They get the benefit of creditor protections, you get the money in without a valuation, and you have a way to clear that debt from your balance sheet without paying the money back.
Convertible Equity - Same thing as Convertible Debt, except it’s not treated as debt at any point. Investor gives you money, and you promise to give them equity in the future, typically at the time and on the terms of an equity financing. You get the money in without a valuation and you don’t carry any debt. These are most common for early stage companies raising money from friends and family, or in the context of bridge loans with investors that will be participating in the equity financing to follow. The Simple Agreement for Future Equity (SAFE) pioneered by Y-Combinator is the most widely used format of this.
Final Takeaway
Before doing a financing of any kind, get some advice from a seasoned entrepreneur, investor or professional that knows your industry well. Much strategy goes into the decision of how you structure financings, and these decisions have significant impact on the future of your business.
Feel free to start by speaking with our lawyers. We are familiar with financing at all stages of a business’ life-cycle.
Ink LLP is a business law firm that acts as strategic counsel to ambitious entrepreneurs, investors, and high-growth companies. Contact one of our lawyers to discuss your business and how our team might be able to help you tackle the challenges of your business and the opportunities for growth.
This information is provided for informational purposes only and is not legal advice.