How to Capitalize a Startup or Small Business
If you're launching a startup or small business, one of the first (if not the first) thing to cross your mind is funding and raising money. A great idea, time commitment and dedication are all crucial for any startup – but without money to keep things moving, you won’t make it far. Entrepreneurs and small business owners with little corporate finance experience may not be sure where to start in terms of funding the new venture. So, without further ado, let’s briefly outline the typical startup funding stages and delve a bit deeper in to stage 4 – the professional investors and equity financing stage.
Typically, the funding stages for startups and small businesses look something like this:
1. Founders contributions.
2. Bank loans, line of credit and personal credit cards.
3. Friends and family loans or investments.
4. Professional outside Investment (angel investors or venture capital).
Founders Contributions and Friends and Family
Relatively speaking, stage 1-3 are fairly self-explanatory. The company is typically funded initially by its founders, where the owners contribute their own personal funds to the company or borrow money in their individual name. In exchange for their initial investment, founders of a corporation typically take shares of common stock. After exhausting personal assets, startups and small businesses will usually look to outside funding sources with whom there is a prior relationship, such as banks or credit unions where the startup or small business has accounts, as well as friends and family.
Keep in mind that, statistically speaking, most startups won’t make it to stage 4. However, we’re optimists here at JNF law, so assuming you’ve made it to stage 4 (congrats!) let’s discuss a few of the most common types of professional investments available to startups and small businesses.
Professional Investment: Convertible Debt
Often, the first form of professional outside investment is a convertible note, or convertible debt. A convertible note is simply a loan made by an outside investor that may later convert in to ownership (i.e., equity) in the company when the company successfully raises its next round of capital, making this essentially a hybrid – combining both debt and equity (i.e., an ownership stake in the company) in one instrument. On the debt side, there is a regular repayment plan and an interest rate, and the investor can even secure the debt with a security interest in the company’s assets. The debt gives the investor much more certainty that the debt will be returned.
On the equity end, upon the occurrence of a particular event described in the agreement between the investor and the company (such as a major investment round or sale of the company), the outstanding principle and interest under the instrument converts into equity (i.e., ownership) of the company, at a rate determined in the instrument. Typically, the instrument provides that, on the occurrence of the stated event, the investor’s debt converts into equity at a discount relative to new investors, as a reward of sorts for investing in the company early.
Professional Investment: Preferred Stock
Typically, the next round of professional investment after convertible debt is preferred stock, raised in sequential rounds often referred to as a “Series A”, “Series B”, and so on. Unlike convertible debt, preferred stock is not a form of debt – simply put, professional investors contribute capital in exchange for an ownership stake in the company, in the form of preferred stock.
You’ll recall that the founders typically take their ownership in the form of common stock in the corporation at startup, which gives them the right to vote those shares at a shareholder meeting. In contrast, professional investors typically require their stock to have certain preferential terms, rights and privileges over common stock – hence the label “preferred stock”. The particular preferences, rights and privileges of preferred shares typically include preference being given to preferred shares in the payment of dividends, liquidation, voting, and redemption, among others. However, the preferences are entirely negotiable between the investor and the corporation, and none are mandatory. The proposed preferences and privileges are typically set forth in a terms sheet given by the corporation’s founders to prospective investors.
If you need legal assistance or simply have questions about how to capitalize a business, or if you have other questions concerning startup or small business, please contact us.