We’ve been talking about capital raising in our most recent Startup Playbook posts, which got me thinking: we need to talk about capital.
Generally defined, capital is a finance resource used to produce value in an economy. There are three types of capital that you can raise for your startup company: (i) equity, (ii) debt,and (iii) non-dilutive funding. It is important to understand the difference between the three. We like to think of the cash (i.e., money) we receive from these investments as being very fungible, and it is. But the capital represented by the cash comes with all sorts of rules. Rules that dictate how we work with our investors and generate returns for them.
Let’s dig in and explore the differences in each type of capital:
Equity is capital that is invested in a company in exchange for ownership in it. The investor’s ownership in an equity investment is represented in shares of the company’s stock. Equity investors will often track their ownership stake in two ways: (i) by the total number of shares they own and (ii) by their ownership percentage. Ownership percentage is particularly important, because with it usually comes benefits of control.
Equity owners (i.e., your shareholders or stockholders) have the power to vote for the board of directors, who in turn appoint the CEO and other officers of the company. Equity owners possess the rights set forth in the company’s charter and stockholder’s agreement, the latter of which the company and shareholders agree to when an investment is made. Stockholder agreements govern how shares are voted and who has certain rights associated with the company—from the rights to board seats to the right to participate in future offerings.
Equity ownership is not all the same. It is typically divided into classes of stock, starting with common and then proceeding to Series A, Series B, Series C, and so on. Founders will receive common stock. Stock option holders will receive common stock as well, upon exercising their shares. Investors will receive Series shares (i.e. Series A or Series B), which are also referred to as preferred shares, because the primary attribute that separates the series of stock is liquidation preference.
Equity owners want the right to participate in future offerings, because they get diluted the more capital you raise. But the hope is that it isn’t a problem because the value of your stock goes up. That’s the deal you make with an equity investor. You don’t have to pay back equity (like you do with debt). Rather, you need to make the company more valuable (first) and more liquid (second), so you generate a return on their equity investment.
Equity investors calculate the return on their investment based upon the amount the value of each share increases (the multiple of invested capital—or MOIC for short) and the time it takes for the value to increase (the internal rate of return—or IRR). It is wonderful for you to return 3X the capital you received from investors, but not if it takes you 15 years to do it.
Ultimately, equity investors will want to receive their money back by selling their shares. This sale could happen in a secondary offering, an initial public offering (IPO), the acquisition of the company, ora recapitalization of the company (i.e., the company buys the shares back). This sale represents the end of the journey for the equity investor, which is why equity investors will always ask about your exit plans. Sometimes you’ll see dividends associated with the stock granted to equity investors, but no equity investor makes an investment with the goal of getting dividends and it is rare that a board votes to declare a dividend.
Equity investors don’t know exactly the return they will receive, but they will seek a more dynamic return than a debt investor will seek. And equity is junior to debt when it comes to returning capital to investors. The bottom line: equity has a higher cost of capital than debt, but that doesn’t automatically make debt better.
Debt is a loan. A lender loans the borrower (i.e., the startup), a certain amount of money (the principal) and requires the borrower to pay an interest rate on the outstanding principal amount until the principal is repaid. Lenders may require the borrower to pay other fees, such as origination fees and/or prepayment penalties.
Lenders know exactly how much they will make on a loan, as their return is represented by the interest rate on the outstanding principal. They know when they will make their money, because the loan will come with are payment schedule. They know who will pay it—the borrower (you better be paying it—if someone else is paying your loan, there could be serious tax implications).
Sometimes, the loan is structured so you pay principal and interest. Other times, you pay interest only for a specific period of time before you make the principal payment in one installment (i.e., a balloon payment). When the terms are very favorable to the borrower, there is a period of no interest or principal payments at all. But don’t worry, the lender is still making money because interest is accruing (you’re just not paying it).
Debt can convert to equity, hence the term convertible note. Convertible notes are a common means by which very early-stage investors invest in a startup when it is hard to value a company, or unwise to do a priced round (usually because legal fees are excessive for the amount invested). When convertible note holders invest, they usually have every intention to convert the principal and accrued interest into equity. But at the beginning, it’s still debt! Equity, however, does not convert into debt.
Lenders don’t sign the stockholder’s agreement because they are not stockholders. Instead, the borrower will sign a promissory note (i.e., the promise to pay) and a loan agreement with the lender. The loan agreement will come with plenty of rules (typically referred to as covenants) about what the borrower can and cannot do with the loan proceeds and what permissions the borrower must get from the lender before taking certain actions with the business. Loan agreements can often be more restrictive than stockholder agreements when it comes to how you operate the business, so be sure to review them carefully so you don’t restrict your operations too much.
Taking debt is non-dilutive, which is great for the shareholders of the company. But—and this is a very BIG but—there are two challenges with debt which must be understood at the time when the loan is made:
If you can service debt with cash flow from the business (rare with startups) and/or if you have a clear plan for repaying or converting the principal, then debt could be for you. It is a lower cost of capital than early-stage equity. Debt can often accompany an equity investment to reduce your overall cost of capital (re: venture debt). But beware of debt. Once you take it, the loan sits on your balance sheet as a liability and the loan agreement could restrict how you operate your business.
In some cases, the presence of debt could even prevent you from raising future capital. No equity investor likes to hear that the proceeds of their investment are being used to pay off existing debt. Proceed with caution.
Non-dilutive funding is capital you receive from a source that doesn’t require you to give equity in return. In other words, it is non-dilutive to the owners of the company.
For early-stage companies, non-dilutive funding can be a fabulous—and I mean fabulous—source of capital. It usually comes in the form of a grant from an entity that has a goal of supporting the type of innovation that the startup is tackling.
Grants require you to apply. There are applications to complete, plans to fill out, and sources and uses statements to provide. You may have to interview for the grant. This whole process takes time, but fundraising for equity or debt does, too. Just be sure you understand the timeline for submissions, decisions, and delivery of funds. If the grant is important to your business, it doesn’t hurt to get help with your grant application.
Many grants also have reporting requirements. Grantmakers want to know if you did what you said you would with the money. In other words,grantmakers want to see the results so they can tout the success and value of their grant program. Understand what those reporting requirements are and be prepared to meet them.
Some grants have strong signal value. A grant award from a competitive state or federal grant program could send a signal to other investors that there’s merit to what you’re building. Receiving a grant is a great time to follow up with investors in your pipeline, share the news, and seek investments to ideally match the grant. For equity or debt investors who are matching the grant, they receive double the technology development for their investment (because the grant is non-dilutive).
Beware of grants that convert into equity. Also be mindful of the tax implications of receiving each grant. Setting those few concerns aside, enthusiastically pursue grants that will fund your business without diluting your ownership.
Non-dilutive funding is fantastic, but it will not provide all the capital you need (nor is it intended to). You’ll have to pursue equity, debt, or sometimes both for your business. Both equity and debt have their benefits, but the ultimate reason you prefer equity as a startup is pretty darn simple: you don’t have to pay it back.
