There are traditionally three primary ways to raise capital for an early-stage company. Founders can sell equity to investors or contract with them for a note that will convert into equity at some point in the future. They can also approach a venture bank for debt financing. Different kinds of financing are available depending on where a venture is at any given time and how they plan to utilize the funds.
Equity is most common way to raise capital
If the company is raising significant funds and it is at a stage where a valuation can be appropriately determined then the sale of equity is the most common way to raise capital. When companies are between round inflection points it can be difficult to determine an appropriate valuation. Convertible debt is often used in this situation because it does not require setting a valuation. The capital is structured as debt with interest which will convert into equity at a discount when the company raises its next priced round in the future. This is often called “bridge” financing because it is designed to cover a cash flow gap to get the company to the next valuation inflection point or past some other major event that will significantly affect the company’s valuation.
Convertible debt can buy time as value rises
Convertible debt is appealing to founders because it is quick to paper with minimal attorney fees and diligence. More importantly, it enables current shareholders to avoid unnecessary dilution by buying them the time they need to validate a higher valuation.
Investors also like convertible debt because it usually provides a nice discount on the next round, interest, and often a “cap” i.e. a not-to-exceed valuation on the next round for conversion pricing. Since the debt is usually secured by all the assets of the company, in a worst-case scenario, note holders know they will be at the top of the creditor stack ahead of all shareholders.
Venture debt offers a safety net
For larger and longer-term debt financing, venture debt is preferred and generally set up as a credit line. Usually this is provided by a venture bank coinciding with a major investment round. Venture banks realize the higher risk associated with early-stage lending and are compensated for taking that additional risk via higher origination and interest rates as well as warrants i.e. the right to purchase a nominal number of shares at a fixed price in the future if they choose.
One may ask why a venture debt credit line is usually established at the same time a large venture capital cash infusion has just been raised. This is the time when the banks are most eager to provide such lending. They generally require that the company use all their banking services as part of the terms.
These credit lines often remain unused or minimally used by the company. They are viewed as a safety net or as a slush fund for opportunistic acquisitions, etc. Venture capitalists want to see their money spent to grow the company quickly and often encourage an aggressive forecast. Knowing they have a credit line in place if needed allows a management team to be more aggressive with its top line growth initiatives.
Mind your covenants
I would be remiss if I failed to add this warning. Many times, I have seen a company fall out of compliance with its bank covenants. Bankers build triggers into their loans that can force their loan to become due immediately if a company’s financial ratios fall below predetermined targets. Busy management teams sometimes fail to check their financials each month against their bank covenants. The loss of a top producing sales person or even a delayed major receivable can force an early-stage company briefly out of compliance. There are few things worse for a CEO or CFO than to unexpectedly have their credit line turned off which can also put them into a difficult position with their board.
Never run out of money
The number one rule for every startup CEO is “never run out of money.” This can require maintaining a complex balance like suffering the edge of a wave leaning forward and back as necessary. A CEO needs to garner all the resources he or she can to grow as fast as possible but at the same time carefully monitoring cash flow, budget and covenants while having multiple contingencies in place for even the less likely scenarios that could materialize. There are many mistakes from which a CEO can recover. Running out of money is not one of them.