In this blog series, we review the most common types of securities used in financing emerging companies, and highlight key issues worth considering for each.  Over the course of four posts, we’ll touch on the sale of (1) equity securities, (2) convertible debt, (3) SAFEs/KISSes, and (4) debt (non-convertible), non-dilutive funding and bootstrapping. In this first post of four, we address the financing of a venture through the sale of equity.  

Equity

When people hear the word “financing,” this is typically what they think of: a startup selling shares of the company to an investor at a set price based on a negotiated valuation of the company. Once the terms of ownership are set and payment is exchanged, the investor becomes an additional owner of the company.

A straightforward benefit to issuing equity is that you receive funding without any debt to pay back (note, however, that some shares may have an attached redemption right, which obligates the company to repurchase the shares if exercised by the shareholder after a certain period of time). Another advantage is clarity – you know exactly what percentage of the company the investors are getting today, for how much, and on what terms.

Frontloading these decisions about the specific terms of the investor’s stake does add complexity to the transaction. Perhaps most thorny is determining the company’s valuation, which at the pre-revenue stage is more art than science. Also, institutional investors generally want preferred stock, with attendant rights such as liquidation preferences, protective and participation rights, and board seats. These rights serve to protect the investor’s interest through the ups and downs of the company’s life, but can be onerous for founders, especially for companies that must undergo multiple rounds of funding. Each right must be thought through by the company with an eye toward the future and negotiated, to the extent the appetite (and legal budget) is present.

Operationally, issuing equity means that the company has additional owners, often permanently. The founders’ share of the company will be diluted. Investors often demand board seats, which may mean rights to information about the company and influence over how the company is run. This can be a positive event for the company; an investor may add value by being more involved in operations or fundraising, or providing industry advice, connections and mentorship. Alternatively, the investor may have unrealistic expectations or have different ideas than the founders for the direction of the company, which can result in additional hurdles for founders. Finally, there is an administrative burden associated with additional owners: obtaining approvals can become more cumbersome, and accounting and other administrative services more expensive.

In any event, issuing equity entails a degree of permanence: you typically can’t get rid of your shareholders (and buy back their shares) as easily as you might your lenders. If you do choose to issue equity, ensure that your shareholders are credible investors who bring value to the company, and that you are comfortable with the amount and terms of their investment.

When to use it:

  • Your company has positive indicators for a strong valuation (e.g. high, sustained growth, desirable technology, achieved value inflection milestones)
  • You have confidence in the investor and the value they bring to your venture
  • You have the resources to understand the terms of the agreement and push for a beneficial outcome

In the next post, we will consider convertible debt as an option to fund your venture.