In our new ‘Raising Funding for Your Startup’ blog series, we’re taking you through six steps of raising funding. In the second blog from the series, we’re talking about a selection of a legal form for your investment. If you want to raise funding, you have to give something in return. The three most common ways to get funding are: selling your shares, using convertibles or getting a loan. For each of these, there are detailed financial terms to be settled.
With shares, it’s quite clear. You just have to tell an investor: I want X amount of money for Y percentage in the company. That’s possibly the simplest way to agree funding. After agreeing on the X and the Y, it is clear what company valuation (or share valuation) you are agreeing. Shares are simple, but they also cause a lot of complexity. That’s because valuing an early-stage startup is very difficult. If you get it wrong that can do a lot of harm… and so a lot of startups are turning towards convertibles.
Convertibles are a well-known instrument for startup funding. The convertible is essentially an investment in shares, but with a delayed valuation of those shares. The convertible is characterized by three main financial conditions: the interest, the discount and the cap. The financial conditions you offer depend on what kind of startup you have, in what sector/market it operates and in what stage it is. The best way to find out the current market ranges of the interest, the discount and the cap is to ask potential investors for their opinions. Leapfunder can help you with this process.
The interest and discount are often roughly the same across companies. However, the cap is company specific. The cap is the maximum pre-money valuation that will be used during conversion of the convertibles into shares. The investor benefits from this cap if the company has increased in value beyond the cap. Then the investor receives shares for the lower ‘capped’ price. The cap works as an incentive alignment, that is why it is so popular with both startups and investors, once they understand how it works. The cap has the effect that convertible investors also benefit from a large increase in company valuation, just as the founders do. Always make sure to negotiate the cap with your current and future investors before you start a funding round. Quite often startups set the cap unrealistically high on their own. When that happens, investors don’t invest and no funding is raised.
The difficult thing with convertibles is that there are more variables to think about than with shares. This makes it more difficult to explain to investors who have not invested via convertibles before. With convertibles, you don’t exactly know beforehand how many shares you will receive, there are different scenarios possible. Since there is a cap present, the investment return can skyrocket when the startup performs well. At the same time, the addition of the interest and discount are intended to guarantee a minimum return to investors if the startup performs normally.
Not many early-stage startups receive a loan. The default rate of startups is quite high. It is often said that between 70% – 90% of startups are no longer around 5 years after their launch. When a startup folds, there is usually no collateral left for investors, so they end up losing all their money. The upside with loans is lower than convertibles and shares because they do not directly benefit from the increase of the value of a successful company. For these reasons we rarely see loans being given to startups.
Today it is common for a startup to use convertibles for a lot of their early-stage funding. Convertibles can be stacked until there is enough confidence in a share valuation to make a straight share investment possible.
To learn more about raising funding for your startup stay tuned for more knowledge.