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First Time Founders Series: No. 3 - Outside Capital

09/22/2020

In this third installment of our 2020 First Time Founder Series, we’re going to discuss outside capital options for your startup. 

We ended our first two installments with the caveat that there is a wealth of knowledge out there, with differing opinions. That is especially true for raising outside capital. Many books cover venture capital and what it means to grow your startup with other people’s money. There are even more blog posts and other online resources. Our goal here is not to replace those resources. Instead, we are going to give you the vocabulary you need to know so that you can ask the right questions and review the right resources to get informed and make the best choices for you and your startup.

Do you need outside capital?
Maybe, maybe not. Not all businesses are capital-intensive. You may be able to fund your business with your personal wealth, and some businesses can be funded by their own revenues from the start. If this is you, you may want to bootstrap your startup. Bootstrapping means forgoing other people’s money and instead relying on some combination of your own money and revenues to fund your business. 

Bootstrapping is not for everyone and not for every business. It can be both rewarding and challenging. It is also not a binding choice. You can start as a bootstrapped startup and then decide to take other people’s money to turbocharge your growth. Many successful companies have done this.

Not all outside capital is the same.
There are lots of ways to fund your startup with other people’s money. Most technology startups default to venture capital. But venture capital is not appropriate for every startup. Venture capital is a niche market, and venture capitalists (VCs) make money by investing in high growth companies with the potential for multi-million (billion) dollar exits. VCs are not monolithic, and you will find varying risk-reward profiles. But, compared to other sources of capital, VCs tend to accept more risk in exchange for higher potential returns. 

If you are not looking for high growth or a multi-million-dollar exit, and instead want to grow organically (and maybe never sell or go public), there are many options to fund your business with other people’s money. These include bank loans, grants, franchising, friends and family, and even crowdfunding, to name just a few. Take the time to understand your options. Many cities, Denver included, have small business resource centers to help you find the best fit for your startup.

Let’s talk venture capital.
There are trade-offs when you take venture capital. You will be giving away some (and maybe substantial) ownership and control of your startup, but also receiving cash and getting plugged into a valuable network of potential advisors, investors, employees, customers, and strategic partners.

Different VCs focus on different stages and in different industries. Some only invest in late-stage SaaS companies, and some only invest in early-stage hardware companies. Being attractive to the right VCs is a combination of luck, hard work, and persistent networking. There are entire ecosystems that exist to help you prepare and pitch your startup to VCs. We do not have the space to cover the art of the pitch here. Instead, we are going to review the structure of early-stage venture capital investments. 

Depending on how much money you need, your target VCs, and how much you think your company is worth or will be worth (your valuation), you have a few options.

Convertible Debt. With convertible debt, you accept an investment (the principal amount) that then converts into preferred equity in your next priced round. In a priced round, you and the investors have agreed on the valuation of your company (more below). Great, so that means you can punt on valuation and still issue convertible debt, right? Not quite. Convertible debt converts into preferred equity-based either on a discount or a valuation cap. The valuation cap should reflect what you think the valuation of your startup will be in the future (when the debt converts), not what you think the valuation is today. You want to set that valuation cap high (you are going to crush it). Your investor wants to set it low (they want a good deal). Now is the time to get comfortable with capitalization table math and pro forma capitalization tables. Grab one of the many publicly available pro formas and start modeling. Avoid unpleasant surprises and understand the impacts of conversion now, before you issue the convertible debt. 

Convertible debt comes in a few flavors:

  1. Convertible Promissory Notes. This is your traditional convertible debt and is still favored by many investors. Until it converts into preferred equity, a convertible promissory note is debt. Interest accrues, and it has a maturity date. If it has not converted by the maturity date, your investor may call the note (and you repay in cash), elect to convert the note (on some pre-negotiated terms), or leave the note outstanding. If you go bust or get acquired before the note converts, your investor (as a creditor) is first in line (ahead of your founder equity) for any available payouts.
  2. KISS Notes. KISS is short for “keep it simple security.” 500 Startups introduced KISS notes as simple, open-source documents that any startup can leverage for an efficient convertible debt round. There are two mains versions: one that acts like traditional convertible debt (see above) and another that acts like simple equity (see below).
  3. Safe Notes. Safe (also written as SAFE) is short for “simple agreement for future equity.” Safe Notes were introduced by Y Combinator. Unlike traditional convertible debt, Safe Notes are not debt. There is no interest and no maturity. Instead, Safe Notes are simple equity. They stay outstanding until converted or until paid out in an exit. Because of this, some investors do not like Safe Notes. 

Priced Equity. Some startups skip convertible debt and go directly to a priced round. In a priced round, you have a set price per share. Some basic capitalization table math: your price per share is equal to your agreed pre-money valuation divided by your pre-money capitalization. Your pre-money valuation is the value of your company before the investment, and your pre-money capitalization is the outstanding (or reserved) equity before the investment. If you have agreed that your pre-money valuation is $5 million, and you have issued 5 million shares to you and your founders, then your investor will pay $1.00 per share in the deal. Your investor will be getting preferred equity in exchange for their cash. Preferred equity is senior to common equity, with additional rights and preferences. The extent of those rights and preferences can vary, depending on whether you choose Seed Preferred or Series A Preferred.

  1. Series Seed. Series Seed Preferred is simplified preferred. It often has fewer rights and preferences, but not always. There are publicly available, crowed sourced Series Seed documents that are intended to streamline a Series Seed deal. Search for “Series Seed.” The pre-money valuation in a Series Seed can be all over the map. And you can have multiple Series Seed rounds (Series Seed-1, Series Seed-2, etc.), each based on a slightly higher valuation, before moving on to a Series A round.
  2. Series A. Series A Preferred typically has substantial rights and preferences, including the ability to elect a director, information rights, and rights to participate in future deals. Most Series A preferred deals are done using the model documents created by the National Venture Capital Association (NVCA). These documents are publicly available and include explanations of the terms. There are also books and other researches dedicated to helping founders understand the model terms. Series A status tends to be reserved for deals with a pre-money valuation of over $25 million, trending towards $30 million or above. Some startups have made a business of tracking these trends.

Some formalities.
Both your convertible debt and your priced equity must be approved by your board of directors and likely also by your existing stockholders. Plus, these deals involve several negotiated legal documents. 

Finally, like founder equity, everything discussed here is a security, subject to both federal and state securities laws. Issuing equity to investors is more involved than issuing equity to your founders. Talk to your advisors about securities law compliance before fundraising. There are important rules for who can invest and how you share information with those investors.

The next installment of this First Time Founders Series will discuss onboarding employees and contractors.

Origially posted on the Galvanize blog.

ABOUT THE AUTHOR

Rose Standifer

Co-Chair, Business Section