Smart Money: Pros and cons of funding mechanisms for startups
RENO, Nev. — Every week it seems like we hear about a new startup company in Reno — usually tech-oriented, but not always. Often, the founder has a great idea for a product or service and lots of energy and enthusiasm.
Seldom, however, does the founder have plenty of money to invest in their new business. As a result, the founder has to get that important resource from other sources. This article provides a brief overview of some of the most typical sources of startup capital and the form the investment usually takes.
The most common initial funding is through “bootstrapping” or self-funding. Self-funding your startup has many benefits, some of which include your ability to preserve management control and reduce equity dilution (meaning, you don’t share the profits as much!).
Some successful startups (like Airbnb) have even gone as far as surviving their infancy stage by “bootstrapping by credit card.” Some problems with bootstrapping are (a) there is usually a limit to the growth that bootstrapping can fund; and (b) credit card interest rates are very high.
Entrepreneurs often find early funding from friends and family members. Usually, friendly terms are available, but the amount available is usually limited, and there is a risk of having to tell your mom you lost her money!
Traditional banks have recently begun increasing the amounts of capital they are lending to small businesses and startups. Despite this increase, however, bank loans can still be difficult to obtain for the early stage company.
Another possible funding avenue are loans guaranteed by the U.S. Small Business Administration or grants made by the Small Business Innovation Research Program. If available, these more traditional sources can be terrific for the startup, providing relatively low interest rates and usually limited infringement on management rights.
The next tier of early investors is often referred to as angel investors. These investors are typically high net worth individuals who invest in startups.
These investors will often contribute advice and business experience and are sometimes motivated, in part, by helping businesses succeed as opposed to solely looking at the potential return on their investment. But you cannot assume that because individuals are called “angel investors,” that they are angels!
Venture capitalists make the bigger bets on more mature startups. Typically, venture capitalists are professionally managed funds that invest large amounts of capital in promising startups that are generating revenues and have a potential for high returns.
Because of their larger investment, venture capitalists investigate deals at greater depths and negotiate tougher terms, often requiring significant management control of the company.
Most of the above investments can come in a variety of forms. Most often, the founder (and sometimes friends and family) takes equity in form of common stock or membership interests in a limited-liability company.
With angel or venture capital financing, the investor will want a convertible note or preferred stock. A convertible note gives the investor the benefit of being a lender.
As a lender, the investor has a defined return (e.g., 8 percent on the invested amount) and a more predictable payment stream (e.g., interest-only payments or interest and principal on the first of the month).
In addition, if things do not go as planned and bankruptcy results, the lender has a higher payment priority than does an owner. On the other hand, if things go well, the investor can convert their note to equity at a pre-determined price.
Thus, the investor utilizing a convertible note has the benefit of being a lender and of being an owner. Silicon Valley startups sometimes use a variation of a convertible note called a SAFE (Simple Agreement for Future Equity).
While SAFEs are friendlier for the company, many investors will not agree to this type of investment vehicle as it lacks the key components of interest and a maturity date.
Preferred stock can be structured to provide an investor with many of the same benefits as a convertible note, but it gives the investor voting rights. On the other hand, it has a lower payment priority than debt.
With the many different methods available and nuances involved in financing a startup, it is important to understand the pros and cons of each form of investment and have legal counsel involved in the preparation and review of all financing documentation.
Before taking any money from an investor it is important that the entrepreneur be aware that federal and state securities laws apply. What may seem like an innocent act, such as advertising and soliciting investors on your website, could preclude an entrepreneur from relying on important exemptions from expensive and time-consuming registration of securities.
For a great resource of the entrepreneurial organizations that can assist your startup please visit Entrepreneurship Nevada’s website at: http://www.enevada.org.
Craig Etem, director and office managing partner, and David Lewandowski are attorneys in the Reno office of Fennemore Craig. Craig focuses his practice in a wide range of business matters, including corporate mergers, acquisitions, divisions, consolidation, recapitalization and formation as well as real estate transactions. David’s passion is helping advise budding entrepreneurs and start-ups on business law issues. He was recently named among NNBW’s Reader’s Choice “Best in Business” leaders. For more information, contact Craig Etem at email@example.com or David Lewandowski at firstname.lastname@example.org.
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