There are several ways to accept external funds from investors. Debt is strict and it doesn’t really match a flexible structure like the one of a startup. However, there are some shortcuts where entrepreneurs and investors might find an agreement which would benefit both parties. The entrepreneur has a wide range of instruments which will facilitate the attraction of the most demanding investors.
Startup Financing: Convertible debt
Suppose you badly need some liquidity and none of the VCs you pitched your project to has shown credible interest. On the other hand, some other investors will be willing to grant you a loan in exchange for a high interest rate. It sounds like you will have to take the bet and hope everything is going to work. One solution would be to agree with the lender that in case you are not able to fulfill the obligation, its claim is converted from debt to equity, thus having right to the profits which will be generated once the business has taken off. Sounds like a good backup plan, just in case something goes wrong. Then creative startup financing options come into your rescue and provide you with some fancy tricks to have less odds of living under a bridge. There’s nothing evil in issuing convertible securities so don’t be afraid of them. They’re like those friends you never hang out with but sometimes it’s good to make a call to.
Debt with the option to convert it into equity allows your lender to protect the downside of his investment by providing him with the right on potential development. The carried risk is thus lower for the loan supplier and the interest rate applied is (or at least should be) lower than the same terms without associated option. From the entrepreneur’s point of view the offering doesn’t signal weaknesses in the startup business plan but rather the need to have more flexibility before proving the inherent potential of the idea. This doesn’t imply that the startup is getting involved in a rubbish business, but rather in one which is likely to need a longer development period. You are belittling your company to greedy financiers but bargaining more favorable loan conditions.
In addition, other conditions can be negotiated in order to obtain a more reasonable interest rate, for example priority rights on the first profits or priority to a specific lender in case of liquidation. This indeed grants more protection to them from the insolvency risk.
Do you want to calculate the outcomes of a convertible note? Check out our Convertible Note Calculator
Startup Financing: Preferred stock
Preferred stock allows you to retain the full control of the equity in exchange to a priority right on dividends once they are released. With preferred stock you cannot be forced to squeeze liquidity from the company and therefore it’s not comparable to interest payments. Preferred stocks are considered a hybrid instrument since they are like a sort of debt without fixed obligation and it doesn’t affect your stake in total equity. Also, these securities are excluded from the computation of the equity rights in terms of voting power and therefore won’t affect future decisions. The dividend payments are usually predetermined and tied to a fixed rate agreed between the parties.
If this is the case, negotiate a rate tied to the LIBOR (US) or EURIBOR (EUR). These benchmark rates are the interest which financial institutions apply to loans among them. However the determination of the payment schedule is not entailed by the issue of the security itself. It will be up to the skills of the entrepreneurs to negotiate the best terms.
Preference rights might not only be related to dividends but also to the liquidation of the assets in case your company runs out of business. The option to convert them into common equity might also be considered (see next section). Whichever terms you agree with your investors, don’t forget that the higher the downside protection for the investors, the better conditions you should get.
In addition, the preferred stocks traded in the financial markets issued from listed companies usually carry the callable option, enabling the company to repurchase the securities if the management decides to do so. If included, this option usually becomes effective after a prearranged vesting period. This term might signal your interest being fully involved in your business in a long term perspective and it’s likely to be highly regarded by investors which prefer to harvest the proceed of the investment in a short time horizon.
Finally, what is far more appealing from a VC’s point of view is that dividends received through these stocks benefit of a favorable taxation regime. This is particularly true in the US. Don’t forget to discount the tax advantage that they will achieve in the price of the stocks you issue.
Startup Financing: Preferred convertible stock
Usually preferred stocks are issued along with the option to convert them into common equity, thus called convertible preferred stocks. From the entrepreneur’s perspective, convertible preferred stocks are particularly convenient since usually it offers higher value for the company and less favorable conversion rates for the external investors. The conversion ratio is established at the signing of the contract and is denominated in the number of common share for preferred ones. However, one drawback is that once they are converted, your stake in the equity is diluted since it’s like issuing new securities. But if the turkey is fat enough and you don’t want to share it, I would suggest you to use your insider information to make the investor an offer he can’t refuse and buy the preferred stocks back at a later time.
Each and every one of these securities would deserves a dedicated article however it is useful to have a broad overview of them for two reasons: first, if proposed by the VC, you will know what he is talking about, second, you can improve the position of the investor and then lower the percentage of equity (or the interest rate on debt) required. I hope you get a glimpse of the different securities with this article and, if not all of that is clear, stay tuned for follow up articles on specific securities!
Follow up questions
· What are the LIBOR and EURIBOR and why should I know their meaning?
· Could you improve your situation by trying to negotiate different instruments?
· What is the best type of startup financing for your company?