Raising Capital: Investment Structure
*Please note that this series of articles provides a general guide to navigating a typical capital raise process. While this is based on our experience in previous capital raise matters, it will not be relevant in all circumstances and should not be treated as legal advice.
Congratulations, your team has been assembled and you are now ready to begin the process of securing investment! Before diving into this, however, you should take some time to think about the type of investment that is right for your business.
As you will see, there are many different financing options which may or may not be relevant to you, depending on the size and growth of your business, how much money you need to raise, and more. Choosing the right investment strategy can make or break a business, so it is crucial that you understand the different pathways on offer.
Type of Investment
Debt
This refers to a loan agreement, plain and simple. The lender agrees to lend funds to the business in return for an obligation on the part of the business to return the principal amount plus a pre-agreed rate of interest on this amount. The benefit of a debt approach is that it does not require you to give up any ownership of your business. On the flipside, if trying to raise a substantial amount, many start-ups can struggle to attain suitable loans without having assets to use as security or a track record of solid revenue. It may be that the only loans available to you are from smaller lenders with excessive interest rates, which are often too risky for a small business to take on. You may also be required to provide a personal guarantee against the loan, making you personally liable for repayment of the principal and accrued interest.
Convertible Note
This is similar to a loan but allows for the conversion of the debt instrument into equity if certain conversion triggers are met. This may occur when the company completes a round of equity financing, at the option of either the investor or the company, after a certain period of time or when certain revenue or KPIs are met. The benefits of this financing instrument are that you will typically pay a lower interest rate on the debt component of the loan, and you can delay the issuing of equity (and thus the dilution of existing equity). However, upon conversion of the note into equity, the investor will typically acquire shares at a discount to the market rate.
SAFE
Under a Simple Agreement for Future Equity (SAFE), the investor typically makes a cash payment in exchange for the right to convert that amount into shares on the happening of certain trigger events (such as a round of equity financing). What sets this instrument apart from a convertible note is that there is no debt element. Accordingly, there is no interest rate, date of maturity or repayment requirement (although the investor is typically granted the right to recover their ‘investment’ if they do not wish to convert that amount to shares on the happening of the trigger event). The benefit of a SAFE is that there is no requirement to put a value on the company at the time of issuing the note, although the investor may negotiate a valuation cap restricting the share value at which the cash payment will convert into equity.
Equity
Issuing equity involves an investor subscribing for shares in your company for an agreed price. The company then has this capital available to it to expand, but you must keep in mind that this dilutes the existing shareholders’ interest in the company. For most start-ups, determining the valuation (and therefore the number of shares to issue) can be complex as most valuation methods require revenue. Often, founders put their finger in the air and see what the investor market might value them at.
It is important to decide whether you are merely seeking a financial investor, or whether there are certain strategic investors you would like to target. It is also key that you don’t let a fox into the hen house and spend valuable time, effort and money arguing about the direction of the company.
Stage of Investment
This will typically dictate the type of investment that is suitable for your business. While these options are presented in chronological order based on the life of a business, it is common for companies to skip rounds entirely if they feel this is necessary.
Pre-seed
This is the earliest stage of investment, when a business is just commencing. The most likely ‘investor’ at this stage will be you, your family, your friends and sometimes the fools who will usually issue a loan to the company or kick the business off with an injection of capital on the terms they can afford.
Seed
This stage is usually where you attract interest from outside investors. This is likely to still be early in the life of your business, so you may find that interest is limited to more speculative investors such as venture capitalists or angel investors. As such, convertible notes and SAFE notes will be more popular at this round of funding, as they are less risky for investors and are also simpler to negotiate.
Series A, Series B, Series C etc.
The next rounds of funding are typically used by more established businesses as a pathway to reaching an exit of either trade sale, major share purchase or IPO. From this point onwards, it is more common for investment to occur by way of equity funding – it will be easier to put a value on the business at this stage, and investors will usually be more willing to take on the risk of buying shares in the company.
Depending on where you are at in your business trajectory and what your appetite for risk is, will help you determine which type of investment and the timing of each stage. We see clients sell 50% of their equity in the company at the Seed round and then move fast towards raising a Series A within 6 months. Others carve off small chunks of equity to maintain control. This can mean that when they get to a Series A, there’s more equity on the table, but they may move slower in scaling up in comparison to their predecessor. What will assist, is if you have a strong team that can guide you.
Merton Lawyers is well placed to assist you at every stage of your investment journey. Please get in touch to book a complimentary meeting and discuss how we can help grow your business
In our next entry in the Journal, the Merton Lawyers Corporate Team will be discussing structuring the deal.
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