Many business owners think the primary source of initial funding for their business will come from a bank loan (debt financing). In fact, most banks will never consider providing a loan for a new business except if the founder provides a personal guarantee and pledges some unencumbered (not previously pledged) assets to the lender as collateral. Obtaining a bank loan is far more likely when the business has shown that it has a viable business and economic model and has a history of producing revenue at a level that it can make principal and interest payments. Therefore, startups will need to look at private sources of debt financing until they become eligible for bank financing.
In the absence of the option of a bank loan, many founders believe their only other option is to offer a direct equity stake in the business by selling the investor shares in the pre-revenue business. When a company is pre-revenue, the business represents a very risky investment since they have not proven their business and economic model. As such, the business has to offer huge chunks of equity to attract any interest from an investor, diluting the founder’s ownership.
Except for loans and equity investments from friends and family, few startups will use bank debt nor can they afford to sell an ownership stake directly to an investor before they have a good degree of traction in the market.
To raise private debt or equity from friends, family, and acquaintances to more sophisticated accredited investors, such as angel investors, founders should consider one of several funding options. The following is a list of seven different funding options any business can use when raising private debt or equity.
Standard Principal and Interest Promissory Notes
Most debt financing for small businesses involves the use of a promissory note. A promissory note is simply a document containing a written promise to pay a stated sum to a specified person or the bearer of the note at a specified date or on-demand.
A promissory note is good for debt fundraisers that don’t require much complexity, which makes them particularly suited for raising debt financing from friends and family. There are many promissory note templates that you can download for free from the Internet. Below are some important terms and provisions a small business promissory note should include.
- Interest Rate – The interest rate per annum.
- Maturity Date – How many years until the loan is fully paid back?
- Disbursement Frequency – While bank loans are often paid monthly, companies more frequently choose to make either annual or quarterly payments.
- Grace Period – Some businesses may elect to defer the start of their loan payments until a later date, such as delaying payment obligations until after their business has opened.
- Defer Payments – Few companies execute their plan without hiccups. Issues may force the company to miss one or more payments without being considered in default so they can recover from a short-term cash flow problem.
- Security – Some loans will be secured with all or some of the business’ assets.
- Personal Guarantee – Most promissory notes require individuals to personally guarantee payments are made to the investor in the event the business goes bust or can’t continue to make payments.
- Subordination. Some promissory notes are subordinate to major bank lenders.
Most promissory notes are structured like bank loans and are repaid with principal and interest payments. However, a promissory note does not need to be structured like a typical bank loan. The following are two variations of a standard promissory note when funding a startup.
Interest Only Promissory Notes with Balloon
An interest-only promissory note with a lump sum balloon payment at the end of the term allows a business to make low monthly interest-only payments at the time when the business is most fragile financially, such as when just launching. You can think of interest-only with a balloon as a kind of corporate bond. The principle can be secured by business assets or unsecured like debenture.
At the maturity date of the promissory note, the company may either have the cash reserves to pay back the principal or at least should be in a better place financially to secure a more traditional bank loan with better interest rates and terms.
Revenue Share Promissory Notes
A revenue share promissory note is when the payback on the loan is based on a share of the revenues of the business. You can think about a revenue share as a royalty. Some important terms to include in a revenue share promissory note include:
- Gross or Net Revenues – Gross revenues are earnings before deducting any expenses while net revenues are earnings after subtracting some expenses. Net revenues often exclude returns and/or shipping costs but could include the subtraction of the cost of goods sold (COGS).
- Revenue Percentage – This is the percentage of revenue that is shared.
- Repayment Amount – With a revenue share promissory note, the investor makes their return on a multiple of their invested capital. 1.5 to 3.0 times the invested capital is often typical. The time it takes to repay the investor depends on how well the business does. The faster the business grows revenue, the faster the investor will earn a return and the higher the effective interest rate for the investor.
- Disbursement Frequency – Companies can choose to make either annual or quarterly revenue share payments.
- Defer Payments – A company may be forced to miss a payment without being in default so they can recover from a bad year.
- Security – Some loans may be secured by all or some of the business’ assets.
Promissory Note Investor Perks
When it comes to debt financing, a promissory note can be enhanced to attract investors when combined with some type of investor perk. For example, in consideration for loaning the money to the business, an investor perk may include something like providing the investor with:
- A credit, equal to some percentage of the investment amount, for purchases of the company’s goods and/or services during the first year or two.
- A discount of some percentage off the list price of the company’s goods and/or services either over the lifetime of the investor or over the term of the promissory note
If a business intends to receive more than one round of financing or anticipates a future liquidity event, a convertible note may be a good option. A convertible note is an unsecured loan to the business that converts into an equity stake in the business at some point in the future.
A convertible note includes an interest rate and maturity date. However, rather than paying the investor’s money back with interest like a loan, the investor receives shares or equity in the business when the note “converts”. A convertible note is a form of debt financing because it includes an interest rate that is applied to the principal amount invested until maturity or conversion to stock.
Convertible notes are useful for early-stage pre-revenue investments because they delay the difficult task of figuring out how much the startup business is worth before they go to market. The number of shares the investor will receive is not determined at the time of investment, as is the case with a direct stock sale but is determined at a future point in time when the value of the business should be much higher and can be more easily calculated.
The return to the investor with a convertible note is calculated primarily based on what is known as a Valuation Cap. The valuation cap is a way to reward earlier-stage investors for their additional risk. A valuation cap entitles investors to equity at a lower valuation.
For example, let’s say an investor loans money to a company and because the business has yet to open its doors, they agree on a valuation cap of $250,000. If the business is producing revenue and profits after a year or two and is now valued at $1,000,000, the early-stage investor with the convertible note is rewarded based on the increased valuation of the business.
To be more precise, let’s say that a share price is established at $4 per share based on the $1m valuation at conversion. Since the early-stage investor has a valuation cap of $250k or one-quarter of the current valuation, the convertible note holder would get an effective price at $1 per share which is one-quarter of the current price. By dividing the later conversion point valuation, $1m in our example, by the earlier valuation cap of $250k, you get 0.25. When you multiple 0.25 by the share price of $4, you get an effective price of $1 per share. It is at this $1 share price that the convertible note will convert into equity.
Generally, convertible notes are used by C-Corps and issued as preferred stock over common stock so that investors do not have voting rights and are first in line to receive dividends. However, in more closely held businesses, where friends and family are the investors, the business may be an S-Corp where the S-Corp can issue non-voting and voting common stocks, as long as the only difference in these stocks is in voting power.
If the business is unable to secure a follow-up round of funding, the note becomes due at the maturity date, typically in 18-24 months. Once you reach the date of maturity, the business has two options:
- Payback the principal plus interest (if the company has enough money to do that), or
- Convert the debt into equity.
That said, convertible notes are rarely repaid in cash as in option one above. Instead, the note usually converts to equity at a pre-set target price. However, if the company is not doing well, the investor may push hard for option one, to get their money back, vs having their debt converted to stock in a sinking business. Such an event could force the business to have to file for bankruptcy protection, which is not what a founder wants to deal with.
Because a convertible note is an unsecured loan that converts to stock at some point in the future, they historically have been a popular form of funding for early-stage startups. However, a convertible note is a form of debt financing since it has a maturity date and is accruing interest during the term which is added to the principle. Because of the increased complexity of convertible notes, SAFE is rapidly becoming a more prevalent instrument to secure early-stage funding from investors.
SAFE (Simple Agreement for Future Equity)
SAFE is a commonly used acronym for Simple Agreement for Future Equity. SAFE is less complex than a convertible note since it is not debt. To understand how SAFE is different from a convertible note, we have to compare the two.
While both a convertible note and a SAFE convert to equity at a future point in time, a convertible note has an interest component and a maturity date that places pressure on the business to get to the next funding level as they accrue interest on top of the principle. In contrast, a SAFE is essentially just a stock warrant to purchase stock in a future round of financing. Since there is no interest accruing in a SAFE note, the risk is lower for the founder and higher for the investor.
Convertible notes can be complicated and a lengthy process to develop, however, a SAFE is a simple document that streamlines the process.
Another difference is, while a convertible note can allow for the conversion into equity by skipping say, a stopgap mini funding round during its term, a SAFE only allows for conversion into the next round of financing. Therefore, if the business needs a round of friends and family funding with a convertible note, the conversion trigger can be skipped, but with a SAFE note, the friends and family round would trigger the conversation.
Outsource Early-Stage Funding
Administering convertible notes and to some extent, SAFE notes, can be a complicated process for a company, so websites like Wefunder allow companies to raise capital from investors using either a convertible note or a SAFE note and outsource for a fee, the management of all the technical aspects. Wefunder even offers templates of the agreement that can be downloaded and edited by the company. Businesses that are interested in raising funds with convertible or SAFE notes can simply send their investors to their Wefunder landing page and the platform handles the rest of the process for either a fixed price or a variable fee, based on the amount raised and type of funding method used.
Direct Stock Sales
For a public company that issues shares of stock, the investors make money in two ways. One is from the dividends the company pays. Dividends, like distributions paid by pass-through entities, are a share of the business’s profits that are paid to investors. The other way investors in a public company make money is through the appreciation of a share’s price during a holding period.
Selling stock directly to an investor in an early-stage business or any privately-held business poses some problems for investors. For an early-stage company that has not gained much traction or is not yet profitable, how do you calculate the value of the business? A business valuation is required so you can then divide that business valuation by the number of shares outstanding, to compute the value of a single share.
Without revenue or profit, the only way to try to value an early-stage business is strictly on qualitative factors such as the management team or a company’s intellectual property. Generally, the only direct shares that are ever used to raise capital for an early-stage business come from friends and family that are investing strictly in the management team or from partners that are pooling both their financial resources and skills to start a new business.
Therefore, selling stocks directly to an investor, such as a more sophisticated angel investor, is not practical until much later, when the business is generating revenue and profits and can be valued using both qualitative and quantitative factors.
Second, because shares of a privately held company are not traded on an exchange and often have restrictions on the free transferability of ownership, there is no way for an investor to make money from stock appreciation unless there is a successful exit.
However, once a business has gained traction, and especially if the business has an exit strategy such as positioning itself for acquisition or going public, direct stock sales can become a slightly more likely option. When it comes to selling stock directly to investors, the business has to decide between two directions. Is the selling of the business’s shares designed strictly for stock appreciation based upon a successful exit? Or will the business have to provide both dividends as well as stock appreciation to attract an investor?
No Dividend Stocks
Like a publicly traded stock, the investor is buying equity at a fixed price per share (or unit for LLCs). The value of a share is computed when the shares are purchased. If the company is successful, the value of the stock or unit will hopefully have increased by the time the company is acquired or goes public. Only when the company has an exit event does the investor earn a return. Investors make money by buying the stock when it is priced relatively low and cashing in when the value of the share price is hopefully high. Generally, a direct stock sale without dividends requires that the business is making profits and needs capital to scale. A direct stock sale that pays no dividends is therefore not appropriate for early-stage businesses.
Most business investors hope to have a successful exit to reap the rewards of their risk. While most businesses will want to plow any potential profit back into the business to help it grow, increasing the value of the business, some businesses may be raising money to support expansion goals, such as opening a second location. In these situations, the company may choose to offer dividends to these later-stage investors. The type of dividends they pay can vary. Some businesses might offer a fixed annual dividend per share, while others might offer a percentage of profits. A common scenario is also to “swap” the dividend after the investor’s invested capital is repaid. For instance, a business might share 80% of its profits until the investor is repaid, and then 20% thereafter in perpetuity.
Outsource Direct Stock Funding
Except for offering friends and family members direct shares in a business, the process of offering equity in a business to anyone that does not have a prior relationship with the business or its founders falls under rules established by the Securities and Exchange Commission (SEC). Therefore, the business will either have to be able to afford the tens of thousands of dollars to hire an SEC lawyer to draft and manage its stock fillings, or they can use a website like Fundable to do it for them for a fixed monthly fee. Fundable only allows businesses that have a U.S. presence and only works with accredited investors.
What funding options are you considering for your business?
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