April 28, 2014 Mate

A primer on financing your idea into reality.

Funding your company is paramount.  At what price, do I value my idea?  How should I structure incoming financing from investors?  These are just some of the questions you should be asking yourself before you start negotiating terms with your future investors. For newbie start-up founders, this is an important hurdle to overcome, especially if this is your first time in the game. Not to worry though, there’s a slew of relevant content out there to get you up to speed, and your start-up attorney, assuming he/she knows a thing or two, can guide you through the weeds.

As a basic primer though, there are two commonly used vehicles to get money in the bank. Issuing promissory notes and outright selling a portion of your company based on a estimated valuation of your idea. Notes and equity will be your knights in white satin so to speak. They differ and choosing which is better for you is based on your individual situation, so it would be good to familiarize yourself with them.

Issuing Promissory Notes.

A promissory note is a debt instrument, when bought and sold, memorializes a promise to pay back an investor at a set upon time, usually with interest. The standard terms of a promissory note include principal, interest and maturity date. However, these basic notes, are typically reserved for loans made by the founders themselves. Outside investors, on the other hand, will most likely want what is called a convertible promissory note. The major difference is that these notes have a function where, sometimes at the option of the investor, the principal plus interest of the loan converts into equity in the company. It’s usually the preferred variety, and this is where the negotiation of terms with respect to convertible notes live. In addition to the standard terms of a promissory note, terms such as discount, and target valuation, change of control provisions, among others, come into play. These are the terms you should get familiar with. They are the important and most heavily negotiated buggers.  Selling convertible promissory notes to investors is a common, affordable alternative, to finance your idea without giving up a piece of the pie in the short run.

Selling Equity.

Equity comes in different flavors, and is known as stock. Common and preferred stock are your two major classes of equity, and separate rights and preferences can be tied to these classes of stock. Selling preferred stock, and in individual cases, selling common stock, is another way to obtain financing for your company.

If your idea is at its early-stage, and you have either decided to forgo or take on debt financing, a “seed” round of selling equity would most likely be your next step. The series seed round, as its called, introduces new terms to consider. Although not complex to understand, familiarizing yourself to get a good handle before negotiating would be a wise step.

Voting Rights

With selling a portion of the company, comes, of course giving up some control. The right to vote to approve certain instances from occurring would now be shared with your new investors. Voting to increase the amount of shares the company is allowed to issue and voting to approve any agreements that otherwise would adversely change the rights of the existing investors, are the more major ones. Deciding whether to declare and pay dividends, change the number of directors and sell or dissolve the company, are others.

Liquidation Preference

Yet less heavily negotiated, a set liquidation preference is another term agreed upon while selling equity. Ultimately this term comes into play when the company is going through a merger, sale, reorganization or similar transaction treated as a liquidation event. Basically it defines how the share price will be treated at one of the above events. The norm here is 1 to 2 times the purchase price originally paid.

Additional Rights

The other usual suspects are rights like, a seat on the Board, but at this stage arbitrary; a right to participate/invest in a later round on a pro rata basis, and information rights. Information rights normally means a right to inspect the company’s financial statements retrospectively, quarterly typically, although, could have a different meaning depending on your investors. It would be good to clarify this point with your future investor. Note though, it’s not typical that all your investors get information rights.  As you can imagine, adherence to this obligation can become a time-suck and take you away from growing your baby, and as so, it’s usually reserved for your “major investors”.

To develop from idea to market, takes a just enough amount of time and money, so unless you can boot-strap your company, taking-on funding from outside investors is inevitable. It’s best to work with someone who knows the ins and outs of financing transactions.

Game, on!

[author] [author_image timthumb=’on’]mate-team-member-pic.jpeg[/author_image] [author_info]Mate administers legal documentation for and helps attorneys guide all kinds of companies from incorporation through day to day corporate mechanics, debt and equity financing transactions, mergers and acquisitions and equity compensation matters. Follow Mate @ZgombicMate or connect with him via LinkedIn to learn more.[/author_info] [/author]

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