There are
two categories of capital for entrepreneurs who seek funding from venture
capitalists or angel investors: debt and equity. Debt is borrowed money to be
paid back in interest, and equity, money invested in the business in exchange
for share ownership of the business.
Early stage
companies rarely raise capital through debt with the exception of convertible
notes which are a hybrid of debt and are converted to equity. Those that
provide the capital are private investors, institutional investors, overseas
like banks and leasing companies, and corporate actions like mergers and
acquisitions in the event of an exit from the company.
Besides
seeking outside funding, entrepreneurs may also provide their own funds to
finance their start-ups, a process known as bootstrapping. The primary benefit
is having a higher share when one decides to exit the company or a higher
valuation if the entrepreneur decides to raise additional funding. The obvious
downside is draining personal resources.
Other
strategies in bootstrapping is exchanging the use of the product with services
provided, like licensing (may be costly), trade equity for consulting services,
legal services. These methods are the best way to finance an early stage
company. According to the US FED, over 70% of start-ups are bootstrapped.
Another
source of fund providers is incubators. They are organizations that help
develop early stage companies in exchange for equity share in the company.
Companies get help in management, strategies in growth. Research has shown that
many companies that get past the early stage stay in business. The problems
that may arise with incubators are high dependency, high startup costs, and
businesses remain small.
Early
stage investors look for experience in the management, revenue momentum,
whether the product has a market opportunity, and they look to becoming share owners in exchange for their capital. Raising capital is not an easy
process at any stage, let alone at a startup, since there is yet a business
plan, and there is no track record yet of the business model. Early stage is
mainly provided by angel investors and venture capitalists in the seed stage. They
seek an active role in the company; they invest in companies with a promising
concept, even though at an early stage the company y has no cash flow, and is
yet at a break-even point.
Growth
and late stage investing is by angel investors, private placements,
institutional venture capitalists, a proven business model, and a track record,
or path to profitability. In order for these investors to provide capital to a
company at this stage, they conduct due diligence. The company is under scrutiny
like agreements, financials, history, organizational structure, tax
liabilities, overdue accounts, major expenditures, and reliance on certain
suppliers or customers.
Equity
securities include common stock, preferred stock, options, and warrants. Each
provides different set of rights, preferences, and rates of return in exchange
for capital provided. Common stock is issued to the founders and employees. All
common shareholders have the same rights as the founders. In common stock, they
have voting rights as well as preemptive rights, the right to maintain their prorata
share. When preferred stock is issued
the value is diminished.
For seek
capital investing, debt financing is rarely the case, except convertible notes.
They are a hybrid debt instrument which can be converted to equity. Convertible
notes have conversion discounts, which is a reward given to early stage
investors in start-ups for the risk they are undertaking. Convertible notes are
the most common form of investments in start-ups, since it enables the
entrepreneur to have access to funding.
With
preferred stock it is equity with some debt characteristics. Dividends are paid
before common shareholders, participate in the distribution in the event of
liquidation, have voting and convertibility rights, carry anti-dilution rights
in the event of stock splits, or sale of stock ta a price lower than that the
investor paid.
Convertible preferred
stock can be converted into common stock at the holders’ choosing. They can be
converted at a ratio of 1:1 but adjusts because of stock splits or anti-dilution.
When a company is up for liquidation preferred stock can be exercised. The
investor receives the greater of the original purchase price plus dividends or
percentage of the proceeds. Preferred stock has preferences as the name
suggests, over other classes. Each subsequent issuance of preferred has
preference over the previous (class A, class B, etc..).Bill T. Alexandratos
billnyc60@gmail.com
