Taking on your first financing event was daunting before the global pandemic and feared economic downturn. You are not alone in wondering what it takes to successfully navigate a financing event and how to adapt to current circumstances.
So that you can approach financing with confidence, Attorney Jeffrey Matson (partner at Bennett, Tueller, Johnson, & Deere) discussed different types of financing options and suggested how to choose between them in our workshop: How to Successfully Navigate Your Next Financing Event. Here’s a recap of his presentation.
The Workshop and this Recap are intended to be educational in nature. The information below should in no way be interpreted as legal advice. Always consult an attorney before acting on any of the information presented by Savvi.
Traditional debt
Matson first touched on traditional debt. Just like auto loans, mortgages, or student loans, the company pays the lender the full amount plus interest over a specified time.
Benefits of traditional debt
- The company does not need to give up any equity, and the already existing investors do not need to dilute their shares or profit interests.
- Depending on the lender, payment schedules can be flexible.
- Documenting and tracking debt do not require the steep learning curve required by other financing types.
Drawbacks of traditional debt
- Banks may not lend money at rates startups can afford, especially if the company is pre-revenue. As a result, startups usually find greater success obtaining debt from friends and family than from commercial institutions.
- Companies may need to secure their loans with personal guarantees, equity, warrants, and intellectual property.
- Converting from an LLC to a corporation is usually a tax free process, but if a company has debt, that might make it a taxable event.
Convertible instruments
Convertible instruments are more common for companies still in their angel investment or bridge financing phase. There are different types of convertible instruments, but the most common are the convertible note and two open-sourced instruments created by a couple of accelerators: Y Combinator’s Simple Agreement for Future Equity (SAFE) and 500 Startups’ Keep It Simple Security (KISS) agreement.
Convertible notes
Matson explained that convertible notes are loans that give the lender the option (and sometimes the obligation) to convert debt to equity. Like traditional debt, a convertible note accrues interest, but unlike traditional debt, if the lender converts the debt to equity, the borrower may never need to pay the lender back. The note can convert at a maturity date or a triggering event (such as a change of control or a qualified financing) at a predetermined price.
Convertible notes normally include either a valuation cap and/or a discount rate. Investors using a convertible instrument want to get rewarded for getting into the game early, and a discount rate and valuation cap are both methods companies use to provide these investors with a better deal on their converting equity. A discount rate is a percentage that the investor using a convertible note will pay compared to the other investors in a priced round. A valuation cap is the maximum amount the company can be valued at for the purposes of that investor’s equity conversion. For example, if there is a convertible security with a $5 million valuation cap converting in a priced round having a $10 million valuation, that convertible investor’s shares will be issued at a 50% discount.
Convertible notes can be attractive to investors, as the notes provide investors with recourse if the company doesn’t do well, but the investors can still get equity in the company if they want. Matson recommended, as a general rule, against backing a note with personal security or guarantees.
SAFEs and KISSes
Much like convertible notes, with SAFEs and KISSes, the investor provides the company with funding in exchange for a promise of equity at a future date. These documents usually still contain discount rates and valuation caps, but the majority of these agreements do not include maturity dates and interest rates. Rather, there are certain events that trigger the equity conversion, like a priced round or a buyout. According to Matson, convertible notes were an extremely popular convertible instrument in the startup community eight or nine years ago. While convertible notes are still used, SAFEs and KISSes are growing in popularity. Whereas the convertible note can involve a significant amount of negotiation, SAFEs and KISSes are more streamlined and cut down on legal costs.
They may be more streamlined, but SAFEs and KISSes still require some negotiation. The parties involved will need to negotiate the discount rate and/or valuation cap. And the KISS comes in either the equity version or the debt version. The equity version converts without an interest rate, but the debt version looks more like a convertible note with an interest rate and a maturity date.
Another common provision found in SAFEs, KISSes, and convertible instruments in general is a Most Favored Nation (MFN) clause. With an MFN, an investor can elect to adopt the terms that a company provided to another investor. Because MFN provisions can sometimes make it more difficult for companies to enter into agreements later in the investing process, Matson suggested that, while companies often need to customize their provisions with different investors, companies should try to be as consistent as they can with the deals they provide to their various investors. Even if investors do not use MFN clauses, this practice helps keep the cap table simple and helps avoid situations where investors feel they are not treated fairly.
Benefits of convertible instruments
- Companies receive funding while postponing valuation.
- With SAFEs and the equity version of the KISS, there is no debt. Without debt, not only will no interest accrue, but these instruments will not trigger the same tax burdens when converting an LLC to a corporation.
- Convertible instruments can be even more streamlined than traditional debt, and so investors may not require as much due diligence. SAFEs in particular are relatively simple, and people know what they are getting when they enter into a SAFE. (Matson did note that, because SAFEs still come in various forms, if an investor offers to provide the SAFE, it might be a good idea to do a redline check with the original Y Combinator document.)
Drawbacks of convertible instruments
- Convertible instruments can complicate cap tables and future financing events. These instruments provide investors with discount rates and valuation caps that may affect the cap table in ways not known till the next priced round. This may lead to companies giving away too much equity without realizing it. Matson recommended approaching each convertible instrument analytically and run the different iterations to see how different scenarios may affect the cap table.
- If the convertible instrument involves debt, this can trigger tax burdens when converting from an LLC to a corporation.
- Convertible instruments with debt can also lead to forfeiture of property.
Equity
There are different categories of equity. With common stock, there is less variance in how investors are treated. Common shareholders receive the same voting and distribution rights. With preferred stock, different investors may receive different terms. Preferred shareholders may request different voting rights, liquidation preferences, preemptive rights, etc.
Equity financing usually occur during priced rounds such as a seed round or a series A round. The SeriesSeed.com documents are standard for a simple seed round. The National Venture Capital Association documents are also widely used but are more thorough. These documents are more common for series A rounds.
Benefits of equity financing
- Equity financing requires a valuation of the company and its stock. This triggers the convertible notes and simplifies a cap table.
- If no debt is involved, there is no need to pay back the investment.
Drawbacks of equity financing
- Because equity financing dilutes existing investor ownership in the company, it usually requires stockholder consent.
- Due diligence is more rigorous. Investors may ask that a company reset its cap table and/or convert to a corporation.
- Securities issues and laws can be complex, and noncompliance can trigger an audit.
- Equity financing involves higher costs, including legal costs, filing fees, etc.
Conclusion: Choosing the right source of financing
Matson noted that there is no one right way to finance a business and that different factors come into play. The amount that is being invested, the relationship with the investor, whether the company is an LLC or a corporation, the company’s valuation, the stage the company is in, and whether the company has a stable revenue are all factors that should be weighed and considered.
About the speaker
Jeffrey Matson is a Utah lawyer with a proven track record of helping startups navigate their financing events. He likewise has expertise in formation, governance, sale, and strategic transactions. Feel free to reach out to him at [email protected] or 801.438.2033.
The Savvi Founder 