One of the most challenging parts of building a new venture is securing the necessary funding to see it through to profitability, and eventually to exit. In a typical venture, entrepreneurs will need to complete multiple funding rounds over several years.
At various stages of development, the structure of the funding round can differ, depending on a number of key factors. By understanding this process, the entrepreneur will be better prepared to successfully complete each round, to drive overall company success.
There are many ways to fund a new venture. Often the entrepreneur will invest their own money, along with their time, effort, expertise, etc., to get the company off the ground.
In some cases, the entrepreneur has enough personal wealth to fully fund the venture. Even in these cases, it is not always the best course of action to do so.
Raising funding often allows for a more rapid ramp-up of operations, sales, revenues, profits, etc. It also spreads the risk among the investors or lenders.
For a serial entrepreneur, self-funding a company may be a good option. For most, the added stress — financial and mental — can interfere with the successful operation of the business. Thus, in almost all cases, it is advisable to raise money from outside sources.
Before any money is raised, the entrepreneur needs to decide which legal structure to establish — sole proprietorship, limited liability company (LLC), general partnership, limited partnership, limited liability partnership (LLP), nonprofit corporation, s-corporation or c-corporation, etc. This is a critical choice as it can be complicated and expensive to change structure later.
While this decision is highly dependent on the specific circumstances of the company, one key element of this decision should be the manner in which the entrepreneur intends to fund the business.
In the interest of limiting the focus of this article, I am going to discuss using a c-corporation structure, as it is the most common for building a new business with outside funding through investors. Entrepreneurs should seek advice of counsel or financial experts to determine the best structure for their venture.
If the entrepreneur plans to seek funding from outside investors, the c-corporation structure is the most common and most appropriate structure. It is the structure I recommend most often, and allows for good flexibility for structuring multiple funding rounds with a wide array of possible forms of funding — equity, debt or some combination of the two.
When establishing a c-corp, it is best to authorize a sizable number of shares of stock, as well as including language allowing for various forms of debt, and the possibility of preferred stock (more on this below).
The Articles of Incorporation should include language authorizing shares, and also the additional language that leaves the door open for adding more shares if needed, other classes of shares (class A, B, preferred, etc.), and debt.
The more general and less specific the language, the better, so that the Articles do not need to be redrafted and refiled later. Refiling Articles will cost money (not a lot, but it is a pain to deal with). It is far better to write your Articles in as open and general terms as possible, leaving maximum flexibility with regard to future fundraising.
I recommend authorizing at least 10 million common shares, and 5 million preferred shares. Again, this is a minimum, but it is enough to cover at least several funding rounds, if those rounds go reasonably smoothly. The Articles should, of course, leave open the possibility of increasing the number of authorized shares, if needed.
In a very general sense, a funding round can be structured with debt, equity or a combination of the two. Also, in general, it is best to use equity during the earlier rounds, and then, if debt is viewed as a better option, use debt or hybrid funding for later rounds.
There are good and bad aspects of each approach. Equity funding dilutes existing shareholders, but the funding raised does not have to be paid back. Using equity early in the company’s development is fairly expensive, since the valuation of the company is typically quite low (more on valuation below). Debt does not dilute shareholders, but the money must be repaid at some point, along with interest typically.
Because cash flow is usually minimal or nonexistent during the early stages of development, it is typically better to focus on equity funding. Debt can be used with interest due as a balloon payment, either at the end of the term of the notes (after three years, five years, etc.), or at some specified time period in the future to give the company time to generate the necessary cash flow to make the payment.
The risk is that sufficient cash flow will not be generated when that bill comes due, which can force the company into bankruptcy, or force a restructuring of the cap table that is usually very unfavorable to shareholders, including the founders. For these reasons, I recommend using equity and not debt for the early rounds.
I mentioned above that using equity for the early rounds of funding is normally quite expensive. This will be the most expensive equity you sell, other than the seed/friends and family round, meaning the valuation for your venture will be the lowest (typically) that you will use to structure a round. Click here for more information on determining an appropriate company valuation, as outlined in a previous column: “What Every Entrepreneur Should Know About Company Valuation.”
For this reason, it is important to understand that you will need to raise more money down the road. The tricky thing is raising enough money to get the company moving in the right direction, and to have enough to get the company (at least) to the next funding round, while not raising more than you need to accomplish that goal.
The valuation of the venture will likely increase over time, as milestones are achieved, so the equity sold will be progressively less expensive for the company/higher priced to the investors. This balancing act is complex, and it is not an exact science to be sure.
The initial round of funding is generally referred to as a “friends and family” round, because entrepreneurs usually need to raise the seed capital they need to get the venture from concept to initial operations from their family and friends. Often, friends and family will either lend the company money (without any real terms), or will receive some equity, although the amount of equity is usually fairly small.
Seed rounds are typically quite small, and the money raised usually does not last very long, but it serves the purpose of getting the venture off the ground, and carrying it into the first real funding round. A typical seed round can be as little as $25,000 to $50,000 up to perhaps $2 million.
Seed round money usually pays for initial product development, market research, rent for the first office space, minimal staffing and some salaries for founders.
A series A round is one that typical includes investments from a smaller number of angel investors, private equity funds or VC funds that contribute an average of $2 million to $10 million in exchange for equity.
The fund is named after the type of equity investors hope to eventually receive: Series A preferred shares. This implies they will be the first group of investors to receive preferred shares.
I mentioned earlier that it is important to authorize some preferred shares, and this is the reason to do so. Also, if at all possible, it is advisable not to issue preferred shares to any investors prior to the series A round. The series A investors tend to dislike cap tables that already have preferred shares outstanding. This can vary, depending on the investor or fund, but it has been my experience.
Typically, there are several additional rounds between the seed round and the series A round. For these rounds, it may be necessary to add a “sweetener” to the offering.
The typical way to do this is to include warrants attached to the shares offered in an equity round. Warrant coverage can range from 5 percent or 10 percent to 100 percent or more, depending on the overall structure of the round, the valuation, the amount of money needed, etc.
After the seed round, if possible, identifying and cultivating a lead investor can be a big help. When structuring a round, if the lead investor has already committed a significant amount to that round, based on the terms offered, it is much easier to convince other investors to come onboard. This is because, often, these investors will defer to the lead investor’s decision regarding the valuation (that it is fair given the stage of development, opportunity presented, etc.), and because, with the lead investor’s commitment, assuming it is substantial, there is a much higher likelihood that the round will be successful, meaning the company will be able to raise the money it needs to execute its business plan.
For later rounds, the use of debt may be more appropriate. Once there is some positive cash flow, the company has more options for funding, including straight debt or convertible debt.
Entrepreneurs can also establish a line of credit with a bank, or may be able to secure funding through receivables financing (factoring), and the like. Just as with equity rounds, sweeteners can be added (warrants or options) to attract a broader base of investors, or to address any pushback on valuation.
I like to use convertible notes with warrants attached, using a schedule of conversion ratios for each year through the maturity of the notes. For example, if the note is a three-year maturity note, the first year’s conversion price could be $1, the second year could be $2, and the third year could be $4. If warrants or options are added, the strike price for those derivatives can also be scaled up.
This structure works well, giving the investor an incentive to convert early, with an opportunity for the company to contact the investor immediately prior to each scheduled expiration of the current year’s conversion price, to provide an update and request conversion. Earlier conversion stops the accrual of interest, removes the liability from the balance sheet, and removes the company’s obligation to repay the principal and accrued interest to that date.
Regardless of how the entrepreneur chooses to structure a funding round, understanding the possible ways to format a round, and to determine a reasonable valuation that will entice investors is critical to success. Once the round is structured, the entrepreneur will be ready to seek out investors.
Finding investors is a topic for another day.
— Craig Allen, CFA, CFP, CIMA, is president of Allen Wealth Management, and has been managing assets for foundations, corporations and high-net worth individuals for more than 25 years. He can be contacted at craig@craigdallen.com or 805.898.1400. Click here to read previous columns or follow him on Twitter: @MPAMCraig. The opinions expressed are his own.
