WTF – What the Finance: The A, B, Cs and 1, 2, 3-6s of Startup Funding
By Kwang Lim and James Struthers, Bennett Jones LLP
So, you’ve identified the problem your company will solve, defined your market segment, polished your business plan, drafted your pitch deck, and practiced in front of the mirror, your dog, your niece, and your cactus. Tough crowds.
After completing all these steps, you may still feel lost in your journey with fundraising. That’s okay!
Today, we’ll go through a little breakdown of some key numbers you should know as you hone in on your financing strategy.
1 Bus Driver
There is only 1 bus driver: the entrepreneur.
What funding mechanism you choose, who you pursue as an investor, the level of control you maintain, and the amount of capital you seek are up to you. Sometimes external forces restrict options, in the same way there are only so many roads to a destination, but the entrepreneur should get a map, do the research, and pick the route.
2 Types of Financing
There are two main types of financing: debt and equity.
- Debt financing is where you pay (mostly later), for money (right now).
- Equity financing is where you give someone a share in your company, or a right to a share in your company, in exchange for money now.
Remember that debt and equity financing aren’t watertight compartments. As you’ll read further on, some forms of financing give investors the right to convert debt into equity, and more rarely, from equity into debt.
3 Stages of Startup Financing
There are typically 3 or more stages of startup financing, but depending on the industry and unique circumstances of the company, the number may vary.
- Seed financing is typically used for nurturing the development of the business idea, bringing a product to market, funding market research, employing key team members, including yourself (so you can feed your children, your dog, your cactus, and yourself), as your company moves towards viability. Amounts will vary greatly for seed financing, depending on the capital needs of the company and investor appetite to invest in the company. There may well be pre-seed funding, where the entrepreneur is spending their own or borrowed money to get an idea to the stage where seed capital is possible to raise. We’ve lumped this pre-seed capital into seed financing, but some may argue it makes up a different stage of financing.
- Series A financing involves a little more cash, and will typically come when the company has shown some success, and there is an opportunity to hone the product or service, and take that initial success to a bigger market base (this is called “scaling“).
- Series B (and beyond) financing are typically similar to series A financing, but on increasingly large scales, and may involve funds used for hiring talent, entering new markets, and strengthening current market shares.
4 Types of Equity Financing
There are four main types of equity financing:
- Common shares can be issued in return for funds from an investor. Shares are basically a bundle of rights associated with a company. Certain shares may allow or prohibit a shareholder to vote on corporate affairs, permit the right to receive a dividend (which is basically a share of the company’s profits) if the directors declare a dividend. Shares typically are last in line to receive any of the company’s assets upon dissolution, behind secured creditors (which are basically lenders with a higher priority interest to all or certain assets of the company) and other creditors and preferred shareholders. Common shares also have value themselves, as they are tied to the value of the company. If the company does well, the value of your shares increases. If the company does poorly, that value may decrease.
- Preferred shares are similar to common shares, only preferred shares have some rights that common shares can’t have, and preferred shares don’t have some rights that only common shares can have. For example, preferred shares may come with a guaranteed dividend, where common shareholders are entitled to a dividend only if that dividend is declared by the company. Also, preferred shares may be guaranteed a portion of the assets of a company upon dissolution, whereas common shares are only entitled to what is left over.
- Convertible notes, or convertible debentures, start as debt but can be converted into equity upon maturity or some triggering event. Basically, a convertible note is a loan, but a loan that permits the lender to convert the money they are owed under the loan into shares in the company.
- SAFEs, or simple agreements for equity. SAFEs are similar to convertible notes but are technically not considered a debt instrument. They were created for simplicity in funding, and so are much shorter and arguably less complicated than convertible notes, and they carry no interest rate or maturity date. Basically, they are a promise to let an investor buy shares at a future date, at a certain price.
We’ll go into more detail on these types of financing in future WTF posts.
High 5 for deciding to become an entrepreneur.
6 Main Sources of Financing
There are six main sources of financing:
- Thyself. Few entrepreneurs will start a company without using some of their own cash, and many entrepreneurs grow their companies just using personal finances and revenue from operations. Different industries may permit, or demand, different levels of bootstrapping, but it will mostly be useful at the pre-seed and seed stages. Bootstrapping can take the shape of both equity and debt, whereby an individual issues themselves shares in their company as a founder in exchange for transferring personal funds to the company, or some entrepreneurs will loan their own funds to the company.
- Thy family and thy friends are a common source of financing at the seed stage and for smaller amounts. Friends and family financing, like bootstrapping, can take shape as equity or debt financing, as friends and family may exchange money for shares, or make loans to the company. Crowdfunding, the process of financing from the public, which can be done with debt or equity, is expanding the notion of friends and family financing, and has gained significant traction with startups globally.
- Banks also fund companies, typically through debt financing. Lines of credit, second mortgages, cash advances, credit cards, all may constitute debt financing. Banks are less likely to enter the riskier world of startups than angel investors and venture capital firms, but participate occasionally. Banks may be involved at any stage of financing.
- Government pours millions of dollars into funding companies in various sectors through grant funding and subsidization. Generally, accessing grant monies requires application, extensive documentation, and there is typically stiff competition for the funds available.
- Angel Investors are typically wealthy individuals with varying motivations who tend to get involved with early stage financing and are often concerned with having a hand in management during this phase of a company’s development. More often than not, angels engage in equity financing rather than debt financing, though convertible notes are a common tool employed by these financiers.
- Venture Capital Firms may be involved at any stage of development, but dominate later stage funding. They typically bargain for a significant share in a company’s equity, and come with experience and knowledge in the relevant field of business. Not all venture capital firms are made alike, but you can get what you give with these investors. Venture capital firms have deep pockets, and sharing equity doesn’t mean giving up control over your company.
Most entrepreneurs are entering the market as FSL – finance as a second language.
Believe it or not, it’s the same for most lawyers at the start of their careers. We, like many others without a background in banking, business, finance, and accounting, (I was a psych major, and most of us are political science, history, sociology, or international development) spend a good deal of our library hours as students, and now our office hours during articles, right there on Google and Investopedia alongside you. Know that you can grasp the basics in a relatively short time even without a business background.
Want to learn more about funding?
Check out our upcoming funding workshops designed for entrepreneurs raising their seed round.
The views and comments expressed in this blog post are those of the authors and do not represent the views of Bennett Jones LLP. This blog was prepared for informational purposes only, and should not in any way be construed as legal advice. Entrepreneurs and companies contemplating financing should seek legal advice.