Small businesses may piece together funding from several different sources—such as bank loans, friends and family, or professional investors.This article will teach you a little more about financing options available for startups and small businesses, as well as a few tips on what you should know about securities laws. It will also briefly touch on the new, easier-to-use financial instruments used to finance and raise money for your startup business.
Ways to Raise Money
Debt vs. Equity
Companies primarily raise capital (money) externally by either debt or equity. A company uses debt financing when a bank or investor loans it money in return for the company’s promise to pay it back, usually with interest and in accordance with agreed-upon terms. On the other hand, a company uses equity financing when an investor gives the company money in exchange for an ownership interest in the business.
One of the major benefits of using debt financing rather than equity financing is that a founder retains ownership of the company. The big downside, however, is that the company must repay the principal loan amount plus any accrued interest, typically over a fixed term. Additionally, debt can have negative consequences on the company’s profit ratio and overall valuation.
The major benefit of using equity financing rather than debt financing is that a company does not need to repay the money at any specific point (unless this is agreed upon with the investor, which isn’t common). The big downside, however, is that the company gives up ownership and control to another party, who now may have a say in how the company is managed and operated.
Who to Raise Money From
Friends and Family
Friends and family often provide a great source of financial capital because they are closest to you and more likely than anyone to believe in your business idea (and in your ability to make the idea a reality). Entrepreneurs may raise money through friends and family through gifts, loans, or equity, but must still observe and abide by securities law requirements.
A friend or family member may give up to $14,000 each year as a tax-free gift, meaning you have no obligation to repay it.
Friends and family may lend you money at below-market interest rates because they are more interested in supporting your business efforts than making money off of it. However, the downside is that you risk your personal relationships if your business fails. To mitigate this risk, you may want to structure this type of financing as a high interest loan for one year.
A company may also sell shares or interest in the business to friends and family, and thus make them equity investors. In this scenario, the lender friend or family member becomes a co-owner in the business. This is the riskiest option for family and friends because there is no guarantee that they will ever get their money back. Securities law also requires companies to comply with various regulations when entering into these “investment contracts,” which can accumulate high fees in professional services to draft and register the investments.
These wealthy individual investors seek to provide capital for start-up businesses, typically in exchange for convertible debt or ownership equity. Angel investors can be extremely useful for start-up businesses because they typically qualify as “accredited investors” for securities law exemption purposes, and because they can introduce the start-up founders to other investors or founders in the same space. However, these investors will not be as lenient towards you or your business as your family and friends, and will generally require you to disclose a significant amount of information as part of their due diligence, both about the company and about yourself and your experience in the field. Additionally, these investors will likely demand terms far more favorable to them than would your friends and family, because they are more motivated by seeing a return on investment than by the altruistic desire to see your business flourish.
As the country recovers from the 2008 credit crisis, banks are starting to lend to small businesses in increasingly greater numbers. This will be debt financing, as banks will rarely, if ever, enter into an equity financing agreement with a startup business. The main benefit of seeking financing from a bank over your friends and family is that the bank will (obviously) have the ability to lend you more capital than your friends and family (unless your friend is Elon Musk of course). The major drawback, however, is that banks typically will require that the loans be fully secured, meaning that if your startup does not have enough assets to secure the loan amount, the bank will ask you for a personal guarantee (i.e. your personal property such as your house, car, or beanie baby collection will be used as security). As you are probably know now from our other articles (or are maybe just learning now), the LLC or corporation is designed to protect your personal assets from liabilities of the business. Thus, if you give a personal guarantee for a loan, you are bypassing this limited liability shield.
Small Businesses’ Obligations to Investors
Business owners who seek funds from individual investors must provide specific factual information to potential investors so that they can evaluate the investment and determine whether it is right for them. The US Securities Act of 1933 and the Securities Exchange Act of 1934 regulate companies’ legal obligations to its investors.
In short, a business that offers a “security” to a purchaser must register it through the Securities Exchange Commission unless it qualifies for an exemption (which is what every small business is aiming for). A “security” covers a broad range of interests such as any note, stock, bond or investment contract. Most small businesses seek to qualify for an exemption since securities registration often comes with a lot of paperwork and prohibitively high legal costs (think, mid to high hundreds of thousands of dollars). The right exemption for a company depends on how the company plans on soliciting investment, the number of investors, and the investors “financial sophistication.” It is advisable to first seek investment from “accredited” investors, or, failing that, from unaccredited investors all located within the same state as the business and with whom the business owner has a prior relationship (professional or personal).
Structuring an Investment
Startups and investors structure investments by using various financial instruments such as stock, convertible notes and, more recently, SAFEs and KISSes.
Convertible Notes are a form of short-term debt financing for the company. In essence, an investor will “lend” the startup capital, and this loan will be governed by an agreement that specifies (1) an interest rate, (2) a maturity date, as well as (3) a discount rate, and (4) valuation cap. The former two come into play if the maturity date on the note is hit, at which point the company must repay the lender the principal loan amount plus interest. However, the latter two will come into play if the company raises capital in a Series A financing round. If this financing round occurs before the maturity date, then the lender’s loan amount will convert into equity (shares) in the company, typically at a discounted rate than what the other investors receive to reflect the risk the lender took by investing in the company at an early (i.e. risky) stage of its lifecycle. Convertible Notes can contain numerous complex provisions depending on the desires and goals of the lender, and if the founders are not financially sophisticated, they may be taken advantage of by more knowledgable investors.
A SAFE, which stands for Simple Agreement for Future Equity, is a standardized one-document security that offers investors a contractual right to buy a company’s stock in the future upon the satisfaction of certain conditions. Thus, SAFEs, unlike Convertible Notes, are considered equity financing tools, and not debt financing.
Startup companies prefer to use SAFEs because these documents are relatively easy to use, typically have no maturity date, and typically do not accrue interest. Some investors, however, may be weary of using SAFEs since they are relatively new instruments with uncertain tax consequences and a lack of certain investor protections.
A KISS, which stands for Keep It Simple Security, may provide a middle ground for those investors unwilling to use a SAFE. The KISS may offer qualifying investors more protections than a SAFE, such as information rights and the right to participate in the company’s future financing. The KISS comes in both debt financing and equity financing form. The debt KISS lacks the attractive features of a SAFE because it accrues interest and matures on a given date. The equity KISS, however, does not accrue interest, and sets the maturity date as the date following which investors may elect to convert into priced equity at predefined terms.
Wrapping It Up
Overall, startups seeking initial capital or small businesses seeking money to grow have several different options available to them. A company may choose a debt or equity structure depending on the founders’ willingness to take on debt or alternatively give up ownership rights. Either way businesses must be careful to comply with securities regulations. Founders may reduce startup costs by using a SAFE or a KISS instrument. If you would like further information on what options will work best for your business, Wilkinson Mazzeo would love to hear from you, so please feel free to reach out with any questions!
By: Jenna Macek
Edited by: Kieran de Terra
Disclaimer: Although this article may be considered advertising under applicable law and ethical rules, the information in this article is presented for informational purposes only. Nothing should be taken as legal advice. Reading this article does not form an attorney-client relationship with us. An attorney-client relationship is formed through a signed engagement agreement. If you would like further information, wilkmazz pc would love to help you out! Feel free to reach out with any questions.
Photo credit: Jackie Wonders