Entrepreneurs have more options than ever to raise capital for their new business ventures. However, with an increase in options comes the difficulty of choosing the best way to fund the business.
Keep in mind that this is very much a high level overview. Each capital raise has its own unique features that impact what it means to be compliant under state and federal laws. There are a lot of ways to have a compliant security strategy, but here are a few points to start the conversation.
Convertible Notes
A convertible note is traditionally one of the most common methods used to raise capital for new ventures. When a company funds the business through a convertible note, they are receiving immediate capital in exchange for debt. The debt will convert into equity at a later date after the company has secured a second round of financing, which is typically at a point in which the company feels it is in a better position to value its stock.
Every business raising capital is looking to obtain that capital for a fair and reasonable price. New businesses often offer equity in exchange for capital, but problems can arise when parties cannot agree upon the value of the equity. The convertible note allows both parties to delay the difficult task of business valuation to a date when the business value is more definite. Furthermore, unlike a fixed price round (more on that below), a convertible note round is much easier (read as, less expensive) to execute. When companies are just getting started, every dollar counts.
This is often why you’ll hear people refer to a convertible note round as a “bridge loan.” The company has an opportunity to establish proof-of-concept, data points, and other key metrics to properly value its business. Investors have confidence in their investment because a convertible note is a loan, therefore giving investors security. The loan will have a maturity date and can build interest during the period that both parties are attempting to determine a proper valuation when a second round of financing occurs.
This option is attractive to young businesses looking for fast capital that don’t have the history to establish a proper business valuation and need to raise capital without committing a lot of money to legal or accounting fees. Convertible notes are equally attractive to investors looking for security in their investment (maturity date and interest), while holding the potential for valuable return once the note converts into equity of the successful business.
SAFE Agreement (“Convertible Security”)
The “SAFE” agreement stands for a “simple agreement for future equity.” These agreements are very similar to the aforementioned convertible note in that the money becomes available to the new business immediately, but are distinct in how the investment is converted into equity.
A SAFE agreement (sometimes referred to as “Convertible Equity”) is an investment of capital into a venture; however, they are not debt instruments, meaning that they do not have maturity dates. The lack of a maturity date allows ventures more time to go through a round of funding or more time to accurately establish the valuation of their venture. Additionally, because SAFE agreements are not loans, interest does not accrue on the invested capital, unlike a convertible note where interest can and often does accrue. Furthermore, while a convertible note will select the definition of a “qualified financing round” which triggers conversion (such as the raise of $1,000,000), a SAFE agreement will convert on the first sale of “preferred stock” regardless of the amount raised.
Investors and businesses are attracted to SAFE agreements due to the lower cost of negotiation compared to convertible notes because the parties do not have to establish an interest rate, maturity date, or definition of qualified financing. In turn, this lowers the cost for both parties to invest the capital to get the business moving (hence the inclusion of the word “simple” within the agreement).
SAFE agreements, while primarily business-friendly, can be rejected by investors because of uncertainty. Absent a clear groundwork for when and how a conversion will take place investors may still lean towards a convertible note, as this gives them power due to the note ultimately becoming due.
Fixed Price Financing
Fixed Price Financing, or “Priced Equity Rounds,” are the most well known and most common investment method for an established startup or small business. The key difference between Fixed Price Financing and other options previously mentioned is that there is a valuation of the company and the company will typically sell “preferred shares” to investors. A fixed price round can be completed either through investment crowdfunding (provided you meet the rules of the JOBS Act Title II, and Rule 506 of Regulation D) or as a “private placement” (private=no advertising or generally soliciting of the investment).
Businesses that are willing to set a company valuation often favor Fixed Price Financing. Often, Fixed Price Financing is achieved in multiple rounds, each time adjusting the company’s valuation and equity accordingly. This strategy allows companies to mature, demonstrate proof-of-concept, get in touch with consumers, and evaluate the success of their business at various stages of funding the company.
Fixed Price Financing is one of the more expensive options to raise capital, as businesses will want to exercise due diligence in selecting the proper valuation for their business as well as carefully structure the rights granted to investors under each new class of preferred shares. Furthermore, because fixed price rounds come into play once a company is established, investors will also want to perform their own due diligence on the company. Preparing the proper disclosure packet that can survive the myriad of representations and warranties a company makes undoubtedly increases costs to complete the deal.
Fixed Price Financing provides the certainty that convertible notes and SAFE agreements do not provide because both the business and the investors have negotiated and determined the company’s valuation prior to investment. In turn, this increases the cost of this capital-raising vehicle in comparison to convertible notes and SAFE agreements. Fixed Price Financing is an option most commonly used for a business that has proven operations and can show a path of scalability with additional funds.
New Kid on the Block: “Investment Crowdfunding”
Until recently, crowdfunding efforts have been associated with donations and “pre-orders” in which people pay a fee in order to receive a product in return. Indigogo and Kickstarter are not structured to sell any securities; rather, they are set up to accept donations and create pre-orders. However, whenever the exchange for capital includes either debt or equity, the SEC gets involved and the rules are governed by Title II and Title III of the Jumpstart Our Business Startups Act (commonly referred to as the “JOBS” Act).
Pre-order crowdfunding offers a great way to test the market before taking your company to the next step. This fundraising vehicle allows you to gauge market interest and gain feedback from potential consumers, enhancing your overall service or product before you look to sell any securities. Many crowdfunding campaigns have gained valuable exposure to their core markets, thereby allowing their businesses to gain momentum that is ordinarily associated with high priced advertising efforts.
Once it becomes time to fund your business, the parameters under which a startup can raise funds for equity through crowdfunding depends heavily on whether they will take money from an unaccredited investor. Under Title II, if you take money from only accredited investors there is no cap on the amount of money you can raise, or the number of investors. However, if you take investments from an unaccredited investor per the rules of Title III, you may only raise up to $1 million dollars within a 12 month period, and investors who make less than $100,000 can only invest the greater of 5% of their annual income or $2,000. Furthermore, the offering under Title III must be made via a Broker-Dealer or Portal Intermediary, and significant disclosures are required for companies to help provide transparency (such as yearly audited financials if you raise over $500,000). The factors just discussed are not an exhaustive list, and for a deeper analysis on the distinction between Title II and Title III we encourage you to read this post: Crowdfunding: Understanding Title II and Title III of the Jobs Act.
The recent passage of Title II and Title III has made the ability to seek capital from a wide audience a reality, but the rules still must be carefully followed. Additionally, downstream implications such as a cluttered cap table could hinder your ability to seek venture capital financing after using crowdfunding for investment, and the yearly requirement for audited financials (roughly $10,000 to $20,000 per year) can be a big long-term burden for only raising between half a million and a million dollars. It’s extremely important to strategize ahead of time with an attorney and an accountant to ensure you’re not harming the long-term financial health of the company by selecting crowdfunding for fundraising.
Conclusion
From Convertible Notes to Fixed Price Financing, there have never been more ways to successfully raise capital for your business venture. We have highlighted some of the differences between your capital raising options, but there are many other variations and options to raise capital that can fit your growing business.
If you have any questions, or need assistance as you decide which type of capital raising option is for you, please give us a call at (415) 633-6841 or send us an e-mail at info@bendlawoffice.com.
This Article was written by Alex King and guest author Paolo Visante.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.