This article first appeared in the Union Leader in May 2022
FOR NEW companies with a unique business idea and energetic founders, one of the first issues faced typically revolves around how to pay for it all. Particularly for product businesses (as opposed to service businesses), there is often a need to find funding to bridge the gap until the product is launched and revenue is coming in.
Early on, finding funding can be one of the founders’ top challenges. Understanding the various types of funding that are available and evaluating what options are most appropriate for the particular stage the business is in can help an early-stage company target its approach to raising capital.
Friends and family
Early investments, often referred to as the “seed round,” help support the business until it generates its own cash or gains further investments. The founders’ friends and family members are a great place to start when raising capital because those individuals are motivated to support the entrepreneur and are not necessarily looking to maximize the opportunity for a significant return on investment.
Some professional investors will want to see that the founders have already been able to raise money from those who know them best. With that, it is important to ensure that those involved understand the high risks associated with investing in startups.
Friends and family will typically be willing to purchase common stock, rather than the preferred stock that is expected by venture capital funds. Common stockholders lack the level of rights, preferences and protections that preferred stockholders have. That said, friends and family are also writing much smaller checks. Selling common stock to friends and family is a relatively straightforward and cost-effective way for an early-stage company to raise initial capital, when angel investors and venture capital funds may not be willing to invest yet.
Angels investors, venture capital
After the initial funding round, angel investors and venture capital firms may be available as alternate sources of funding. Angel investors are accredited individuals who invest their own money in early-stage companies in exchange for an ownership interest. In addition, angels generally provide the company with feedback, advice and connections.
Venture capitalists usually get involved in the fundraising process after angel investors, when the business is more established and ready to scale quickly. Unlike individual angels, VCs are firms or companies that pool money from groups of investors into a combined fund, and they are generally able to take on greater levels of risk. While the average angel invests less than $500,000, the average VC deal is upward of $10 million.
In exchange for making a high-risk investment, VCs receive preferred equity, along with significant control over company decisions. While VCs tend to expect a high level of involvement in the business, they can provide valuable strategic advice and networking opportunities. Venture capital is a good fit for high-growth companies that are willing to give up a portion of control and ownership.
Convertible notes and SAFEs
Convertible notes are a popular alternative to issuing equity in the early stages of fundraising. A convertible note is a loan that is convertible into equity at a future point, typically upon the closing of an equity financing that occurs before the debt’s maturity date. Similar to a convertible note, the SAFE (Simple Agreement for Future Equity) is a form of convertible debt that lacks a set maturity date.
Convertible debt usually converts into the type of securities being sold in the equity financing. In that sense, convertible debt can act like a pre-purchase of preferred stock, and investors may be rewarded for making a riskier investment early by receiving a valuation cap or discount.
It makes sense to utilize convertible debt as a funding option if an issuance of preferred equity is realistic in the near future. In that case, it can be a cost-effective way to bridge the company’s financial needs until the equity financing that triggers conversion. Using this structure also postpones the need to establish a formal valuation of the company, which can be difficult early on.
Equity crowdfunding is a framework for startups to raise small amounts of capital from a large pool of investors, including investors that are not accredited. These investments are conducted through one of the funding portals registered with the U.S. Securities and Exchange Commission. Crowdfunding presents an opportunity to bring in smaller investments from a wide range of investors.
However, due to the onerous disclosure requirements, the restrictions and fees imposed by certain portals, and the small investment amounts involved, equity crowdfunding can be more costly, restrictive, and time-consuming than companies anticipate.
Bank financing and hybrid funding
Investing in a startup with limited operating history involves significant risk, making it difficult for early-stage companies to obtain a bank loan or complete a debt offering. Until a company has a track record and collateral, it is unlikely to qualify for conventional bank financing. With that, New Hampshire has several nonprofit regional development corporations that offer hybrid funding options that early-stage companies may qualify for.
When it comes to early-stage financing, there is no “one size fits all” solution. There are, however, a variety of options that startups can turn to for raising capital and growing their business. Ultimately, the unique needs of the company and the specific stage that the business is in will likely drive the determination of which options are most likely to be successful.
To learn more about funding options for startups, tune into the New Hampshire Tech Alliance’s webinar series, Startup Funding Explained, starting on June 1. More information available at: https://nhtechalliance.org/startup-funding-explained
Emily B. Penaskovic is a corporate attorney at Cook Little, PLLC, where she advises entrepreneurial clients on a variety of business matters, including entity formation and capital raising from the seed round through Series A. Emily is also on the Board of Directors of the New Hampshire Tech Alliance and chairs NHTA’s Startup Committee. Emily can be reached at firstname.lastname@example.org.