Raising capital is a critical step for startup founders and entrepreneurs who are looking to scale and succeed in their businesses. Founders have multiple financing options, each with distinct benefits and trade-offs. However, three major funding methods are becoming popular in the startup raising capital circle: equity financing, venture debt, and convertible notes. Read on to discover which option best suits your startup’s growth strategy.
The article will explore the three financial options in detail to help entrepreneurs and startup founders with their business growth, leading to smarter decisions for success.
What is Equity Financing?
Growth-oriented enterprises predominantly utilize equity financing, particularly when cash flow projections are challenging to determine. In an equity investment, a company generates capital by offering a portion of its ownership (equity) for sale. The investor will depend on recouping their initial capital and a potential profit during a forthcoming liquidity event, such as an acquisition or initial public offering (IPO), or through the distribution of future profits. As investors acquire partial ownership of the company, they are consequently endowed with voting rights that influence significant corporate decisions.
Stages of Equity Financing
For startups, equity financing advances through several early-stage funding rounds, each fulfilling a specific role in the company’s developmental trajectory.
1. Pre-seed and Seed Rounds
The initial phase of investment, consisting of pre-seed and seed funding, helps startup founders in the development of their products, the execution of market research, and the establishment of a preliminary consumer base. At this juncture, investors typically comprise angel investors, acquaintances, relatives, and early-stage venture capital firms. Investing in equity interests comes with higher risk but also opens the door to the best funding opportunities.
2. Series A Funding
Founders must focus on Series A funding following the accomplishment of product-market fit and initial market adoption. The founders of startups should use Series A funding to enhance their operational capabilities while increasing workforce numbers and modifying their business model. The financial contributors gain between 20% to 30% ownership equity from their capital injection while buying preferred stock shares. This particular type of equity investment gives investors voting power, priority in receiving decisions and dividend payments, and preferred liquidation treatment.
3. Series B and Beyond
The subsequent financing rounds, Series B and Series C, concentrate on business growth, market expansion, and the goal of generating profits. Founders need to establish precise terms during these rounds because large institutional investors want to maintain ownership to maintain control of the company.
Equity financing helps company owners obtain the requisite capital for expansion while offering investors ownership interests and the prospect of financial returns. However, founders must strategically manage dilution and investor rights to maintain control and long-term business success.
Advantages of Equity Financing
Why should a business pick equity financing instead of a bank loan? Here are the key advantages of equity financing.
- Easier access to future funding: Investors are usually willing to offer more funding as the business grows.
- Shared interest in success: Like you, investors really care about the success and growth of the business.
- More than just funding: Angel investors and venture capitalists aid in the growth of your business by facilitating connections with others, advising, and guiding strategic decisions and plans.
- Focus on growth: Investors expect the company to create value, so they help find and support growth opportunities.
- No debt repayment worries: In this instance, retaining funds to repay loans or debts would not be necessary.
- Use profits to expand: All revenue generated by the company may be either retained or utilized for the expansion of the business.
- Your share becomes more valuable: Even though you own a part of the company, as its value grows, the worth of your share will increase.
What is Venture Debt?
Venture debt is a loan for companies in their early stages and is repaid on a set schedule. One of the important benefits is that the lenders are concentrating their attention on the growth potential of your company rather than just the current assets, thereby showing their confidence in your future success. The owners and employees, in this way, are able to keep and still exercise their rights to ownership and control of the company. Besides, such funding would help you expand your operating cash flow, giving you more breathing space to work on crucial achievements. The funding can also secure you better terms and increase your company’s value for the next funding round. Furthermore, it is usually cheaper than equity financing and is also a quicker way of getting funds, which can be beneficial to you since you will be able to invest quickly in growth opportunities.
Pros of Venture Debt
Now, we will look in detail at the advantages of venture debt and how it can help your business.
- Retains ownership equity: Venture debt helps source capital and preserves ownership dilution. As an entrepreneur, it allows you to strengthen yourself and maintain more equity in your venture.
- Affordable financing option: It’s usually a cheaper option than equity financing and traditional loans, leading to long-term savings.
- Flexible repayment options: Offering more flexible payment terms to businesses than those in traditional loans helps them control cash flow and develop. As a result, they are able to pay off debts more easily.
- Fast access to capital: Raising venture debt is usually quicker than raising equity, so you can have the necessary money right away.
- Extra support from investors: Most suppliers offer strategic advice and operational help, and this can really boost a business’s growth.
What are Convertible Notes?
Convertible notes are structured as debt instruments; however, they include provisions that permit the principal amount and accrued interest to be converted into equity investments at a subsequent date. This facilitates a more expedited investment process, resulting in reduced legal fees for the company at that time while simultaneously providing investors with the economic benefits of an equity investment. The duration of terms may vary from a minimum of 6 months to a maximum of 24 months.
How is it structured?
Convertible notes are a bridge between debt and equity financing, serving as a link where the main considerations are interest accrual, maturity date, conversion terms, and discounts. Investors and companies need to comprehend these.
- Interest rate: The capital invested earns interest as a return. Unlike venture debt, these debts aren’t paid off in cash right away; instead, the amount owed to the investor grows over time.
- Maturity Date: Convertible notes possess a maturity date, at which point they become due and payable to the investors unless they have already been converted into equity.
- Conversion Provisions: The principal objective of a convertible note is to facilitate its conversion into equity at a subsequent point in time. At that time, the original principal and accrued interest converted into shares of whatever new equity was just sold. In addition to the accumulated interest that enables investors to acquire more shares than they would have by delaying their investment of the same capital, investors frequently receive supplementary benefits as an incentive for investing at an earlier stage. When qualified financing does not occur before maturity, certain convertible notes include provisions for automatic conversion to equity at a predetermined valuation upon reaching maturity.
- Conversion Discount: Convertible note holders get the chance to convert their debt into equity at a 15-25% discount compared to future investors.
- Valuation Cap: Convertible notes generally incorporate a valuation cap, which serves as a definitive limit on the conversion price for noteholders, irrespective of the share price established in the subsequent round of equity financing.
Advantages of Convertible Notes
Convertible notes, a special financing option for young firms, offer advantages of both debt and equity. Let’s explore their key benefits.
- Deferred negotiations: With a convertible note, the startup can delay deciding the company’s value until later, which could lead to a higher value. It’s a win for both sides, saving time and money.
- Advantages for investors: Investors are afforded security in this arrangement, as they initially function as debt holders and subsequently transition to equity holders when the company’s risk diminishes. They are also afforded numerous supplementary benefits, such as discounts or valuation limits, to compensate for the risks they undertake.
- Minimal complications: In contrast to equity funding, a company is not required to be registered as a Limited Liability Company (LLC) or a C Corporation to secure financing through a convertible note. Furthermore, the procedure entails reduced documentation and diminished legal expenses.
Comparison of Equity, Debt, and Convertible Notes
This comparison helps you understand the basics of equity, debt, and convertible notes.
| Equity Financing | Venture Debt | Convertible Notes | |
|---|---|---|---|
| Ownership | Yes | No | No until it converts to equity |
| Voting Rights | Yes | No | No until it converts to equity |
| Repayment of Capital | No repayment until the company is sold or through buybacks | Paid back on a fixed schedule | Paid back when the note matures or if converted into equity |
| Dividends/Interest | Dividends may be optional and can change | Interest paid on a fixed schedule | Interest accrues; typically paid back or converted into equity |
| Payment on Sale of Company | Paid after debts and other obligations; receive investment + share of remaining proceeds | Paid before equity; receive investment + any unpaid interest | Typically paid before equity; receive investment + any unpaid interest |
Choose the Right Funding Option for Your Startup
In summary, startups have numerous paths to raise money, each of which has its own advantages and disadvantages. The right choice depends on how developed the startup is, how much money is needed, and the long-term goals.
Venture debt gives startups an alternative to attract new capital without sacrificing ownership or compromising the financial health of traditional loans. It is a wise approach for companies willing to expand and keep their financial situation stable. Find out if you qualify for venture debt and explore new opportunities for expansion.
Also, if you need a business bank account that helps with your growth and managing money, Cheqly has flexible solutions that are perfect for startups.