When starting a business, companies face many challenges, not the least of which is fundraising. A company beginning to solicit investments is embarking on a journey that could seriously impact its ultimate success.
With different benefits and unique limitations, choosing the right structure for early stage financing can be daunting. Below are the pros and cons of three common financing alternatives: equity financings, convertible debt financings and a hybrid of the two, convertible equity financings.
Equity financings tend to be the most complex type of fundraising available to companies for a seed raise. The financing documents for an equity financing can be long and include a number of terms to be negotiated between the parties. Investors and founders engage in determining the value of the company and what the relationship between the company and the investor will look like moving forward. Usually, in return for their investment of capital, investors receive preferred stock in the company, although in some cases equity financings can involve common stock.
Pros of equity financings:
- No ambiguity with respect to the company valuation; all parties are informed and have agreed on the perceived value of the business.
- Unlike debt instruments (g., convertible debt issued to investors or a loan from a bank), equity financings do not have to be repaid, because the money is exchange solely for an ownership share in the company.
- Many investors and companies view the ability of the parties to negotiate all the terms of the investment as a key benefit of equity financings. The detail included in the definitive transaction agreements for an equity financing allows the parties to ensure that their rights and obligations are clearly defined.
Cons of equity financings:
- Reaching agreement on terms or valuation at such an early stage can be difficult.
- Many companies at this stage have only conceptual product offerings and no revenues.
- If the agreed upon valuation is too low, founders and early employees will experience unnecessary dilution (reducing their ownership in the company), or if it is too high, this could lead to a “down round” financing in the future.
- Equity financings often have high costs.
- Although some resources (such as form documents) are now available to companies to reduce the cost of an equity financing round, much of the value of equity financings results from negotiating the terms and customizing the agreements. This process can be relatively costly and time-consuming, and, particularly in seed financings, the costs might be equal to a substantial portion of the capital being raised.
A second alternative financing structure, convertible debt, addresses some of the cons associated with an equity financing.
In recent years, convertible debt has become increasingly popular as a way to fund early stage companies. Unlike equity financings, convertible debt provides a relatively quick, inexpensive and often simple financing structure. When convertible debt is used, the company and investor will structure the financing as a loan to the company with an interest rate and maturity date. At the end of the term, or upon some pre-determined future event (usually a Series A round), the outstanding debt (initial investment and any accrued interest) will be converted into equity. Generally, in order to incentivize investors to make a risky, early investment, the investors will be entitled to some discounted rate or a warrant as a “sweetener.”
Many investors request that companies include a cap on the valuation at conversion in convertible debt financings. This cap may undermine, to a certain extent, one of the advantages of a convertible debt financing structure — the ability to defer a valuation determination until the company advances beyond the seed stage.
Pros of convertible debt:
- Convertible notes are simple documents with typically lower legal costs.
- Compared to equity financings, convertible debt is often easier to negotiate. There are fewer terms to discuss and each note can be customized more easily.
- The company and the investor have the ability to delay negotiations regarding valuation and key terms.
- Unlike equity financings, convertible notes are usually relatively minimalist agreements, with both the investor and company agreeing to defer decisions on key terms and leave the negotiations for the venture capitalists and the company in a later round, typically when legal and other administrative costs will be more easily absorbed.
Cons of convertible debt:
- While the ability to delay valuation is one of the key pros of convertible debt, this delay leads to uncertainty regarding the percentage of the company that investors will own upon conversion.
- Carrying debt on the books may cause undesirable effects on the company.
- If no conversion event occurs prior to the maturity date of the note, then the investor could demand repayment of its investment. Often times the business will not have capital on hand to meet such an obligation. However, if a conversion event is close and the investors continue to support the company, investors are often amenable to negotiating an extension of the expiration date of the note.
In an effort to avoid the potential drawbacks associated with debt instruments, a third alternative financing structure has been gaining popularity: convertible equity.
Convertible equity is similar in structure to convertible debt, but eliminates the features that lead to a classification as debt. Rather than being structured as a loan with interest due and a maturity date, a convertible equity financing would generally accumulate no interest and have no expiration date. The investor would still be able to convert the investment into equity upon the occurrence of some future event, but would not be able demand repayment of a loan. Investors may be willing to accept this method of financing as they are typically not motivated by the minimal interest returns on a debt instrument, but are instead looking for a much higher return on investment. Therefore, the absence of interest or an end date is likely not important to investors.
Pros of convertible equity:
- All the benefits outlined above provided by convertible debt are present with convertible equity.
- Convertible equity agreements are relatively simple documents with lower legal costs.
- The company and the investor have the ability to delay determinations regarding valuation and key terms.
- The company has flexibility with respect to timing and terms.
- The company does not incur a debt obligation to secure the benefits of an investment.
- Such an arrangement is often preferable for the company because the investment converts into equity upon the occurrence of some future designated event. If no such event transpires, the business has no obligation to service or repay the investor.
Cons of convertible equity:
- Investors may not be interested in or may be wary of convertible equity.
- Some investors are unfamiliar with convertible equity and may be hesitant to invest in convertible equity due to concerns over how these agreements will be treated when unexpected events occur.
- The familiarity with convertible debt and the status of a creditor may be important to investors.
- Some investors may be interested in earning interest on their investment and establishing priority as a creditor.
Choosing the right financing structure at the seed stage can impact a company’s future in the long run. While each of the three financing structures discussed above has a series of pros and cons, understanding these differences can help a company determine which structure best fits its unique facts and circumstances.