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Founders & Startup 101: Part II) Forms & Sources of Funding

So you developed the next big app or social media website idea, formed an entity, and developed a business plan, now how do you get funding?

This is the second part of a series of blog articles that will explain in layman’s terms some of the things that every founder should know about the types of equity and how common forms of funding relate to your company’s equity.  All answers and discussion are meant to be educational only and should not be relied upon as legal advice for your specific situation.  I will discuss things generally and as applied in California, so this is not meant to be all inclusive, but a general basic education.

Here is part II:

There are many forms of funding and sources.  This gives a basic description of the most common forms of funding a startup company and where the funding comes from.  This is only a basic brief discussion to give beginners an understanding so they understand some basic terms.

A)  Debt Finance

The somewhat more common form in the last few years has been different types of debt financing, which is to say, a loan to the company.  This can be created in many ways, as simple as an individual investor agreeing to give the company some cash and the company signing a one page promissory note.  The more complex types involve significant legal documents like security agreements, credit facility agreement, security purchase agreement, and others.  There a variety of terms that could be incorporated into a debt deal on when the money comes in, what it is to be used for, when payment is due, rate of interest, and other common loan terms that you may be familiar with from a mortgage or other loan you have had in the past.

The loan agreement is essentially a security in most cases, so there are securities laws and other considerations to execute this type of agreement properly.  One of the most important to the bank/investor is to secure any rights to collateral if the company is delinquent in payments. In many cases with startups, the bank will try to secure any rights to not only the company’s assets, but may ask for personal guarantees.  When the bank seeks this type of security, it is considered a “secured loan” versus an “unsecured loan” when there is no collateral.

Many founders get so blinded by their feelings that their startup is the best idea since sliced bread that they don’t realize the ramifications of signing a personal guarantee.  If the company fails, the bank will take actions to enforce its rights against the founder who signed the personal guarantee.  I have had many people, especially due to recent economic conditions, come to me in the last few years needing to file personal bankruptcy just to get out of these personal guarantees when their company failed.  The bank may require a personal guarantee, so the founder is stuck either accepting those ramifications or having no working capital.

Common types of debt finance:  credit line, bridge loan, straight promissory note, convertible note, credit card debt

B)  Equity Finance

Equity financing is when the company sells equity (ownership interests) to an investor.  See this prior Part I discussion of the types of equity to understand the forms of equity that could be sold. The most common is selling a certain number of shares of common stock in the company representing a certain percentage of the company ownership.  This is most often determined by using a valuation of what the company is worth before the funding (pre-money valuation) and after (post-money valuation).  If it is a more sophisticated investor, group, or, especially with venture capital firms, the use of various rounds of preferred stock, e.g. Series A preferred, Series B preferred, etc.

These transactions involve documents such as subscription agreements, stock purchase agreements, investor representation letters, and other “closing” documents.  Again, this also involves a security, often common stock being offered and sold, so the transaction and process must comply with state and federal securities laws.

C)  Hybrid Finance

I use the term hybrid finance to categorize the different types that aren’t traditional debt or equity finance.  This can include things like convertible notes, where the company is loaned money, but the lender has certain rights to convert their debt into equity in the company.  Usually the lender holds the right to determine when to convert, but sometimes it converts automatically upon the occurrence of a certain event.  For example, say the company is loaned $50,000 and the terms may state that upon the company going public, the $50,000 loan turns into x number of shares of stock in the company.

Some other hybrids include convertible equity finance, such as convertible preferred stock (can be converted into common stock), combinations of debt and equity (loan and stock given to investor), and attaching warrants or options to a debt or equity financing (investor gets the contractual right to purchase stock at a set or pre-determined price).  Someone could also invest money into the company in exchange for discounted options to purchase stock, although I haven’t seen that by itself in the past as it doesn’t give the investor much protection or rights.

There are also gifts, cash contributed by founders, personal credit cards or cash advances by founders, and grants that can sometimes be used for working capital in the beginning which may not be the traditional forms of finance.

All kinds of factors come into play when determining funding options for both the company and the investor such as tax consequences, security/collateral, liquidation preferences, stage of development of the business, and potential exit plan.  Here is a graph showing various forms of funding and, in some but not all cases, their attractiveness/risks for the company and investor.

D)  Sources of Financing

So where do you go to get financing?  There are too many potential sources to cover them all in detail, but here are the more common:

Most common sources for debt financing are small/regional or specialized banks, small investor groups, small institutions, friends and family, and, one of the more common, the Small Business Administration (SBA). SBA loans are actually done through a bank that participates in the SBA program and the government provided a guarantee so that if the company fails, the bank gets back a certain percentage of their loan from the government.

Other sources of debt and equity can be categorized as:  1) angel investors- typically high net worth individuals who look for alternatives or diversification to traditional large company public stock, mutual funds, CDs, and other investments, 2) venture capital- firms that specialize in funding and growing startup and emerging growth companies, 3) friends and family- this is pretty obvious, get your friends or family to give you the money, and 4) institutions- which I classify and include certain divisions of bank, private equity firms, and hedge funds.

In order to pursue these sources, you need to have your idea well developed and thought through, usually best in a business plan.  It is also good to put together a 30 second elevator pitch of your business, 5 minute presentation, written executive summary, and the dreaded full business plan with financial projections and other related exhibits.  Founders often don’t realize that this process involves offering a security in the process (whether in the form of a loan or sale of stock/options) and securities laws are involved.  I will go over private placement memorandums and some of the more common legal and securities pitfalls to avoid during this process in another upcoming section.

Next Section Coming Soon:  Finder’s Fees & Private Placement Memorandums (PPM)

In my next section coming soon, I will deal with the common problem that startups face of when someone says they can bring money into the company through someone they may know, but they want to get paid for bringing the new investor in.  The problem of “finder’s fees” has been a common issue for many years and I will discuss it further in Part III.