Our first round of “Founders Series” articles focused on topics relating to startup formation – including choosing the right structure, tax considerations, a checklist for forming a C-Corp, and important regulatory matters.
To round out this discussion about important items for founders to consider, we now examine strategies for getting venture capital and other funding for a startup. From the inception of a startup company until it becomes a consistently profitable business, all companies have something in common – the need to finance operation and growth.
Here are the various ways you might finance a new company:
Generally bootstrapping occurs when a company is funded solely by the founders without assistance from external sources of capital. Doing so provides founders with the greatest amount of flexibility in terms of running the business but also requires the founders to take on additional financial risk.
A seed financing typically involves a relatively modest amount of capital invested to fund the investigation of a market opportunity or the development of the initial version of a product or service. Seed financings are often provided by the founders themselves, “friends and family” or angel investors. Typical seed financing structures include:
- Note Financing – an investor will receive an interest-bearing promissory note in exchange for their investment, which is either repayable upon demand by the investor or upon a stated maturity date. A note financing is often the simplest investment structure and is often used by founders or “friends and family” investors to allow a company to maintain its operations for a short period of time before an anticipated influx of capital, such as a Series Seed or Venture Capital Financing or receipt of customer revenue.
- Convertible Note Financing – bearing promissory note in exchange for their investment, and while such note will include a maturity date for repayment like a traditional note, it will also include the option/requirement that it be converted into equity (sometimes at a discounted rate or subject to some maximum value) at the time of an equity financing.
- Common Stock Financing – investors receive an ownership stake in the company (i.e. they own a certain percentage of the company) in the form of common stock in exchange for their investment in the company. This type of financing can limit ability to issue common stock options at low prices.
- Series Seed Financing – investors receive preferred stock in exchange for their investment in the company. Among other things, investors who hold preferred stock often receive the right to get their investment back (plus an additional return in some circumstances), called a “preferred return,” before holders of common stock are paid upon the sale or liquidation of the company.
Venture Capital Financing
Venture capital (VC) financing typically results in a larger investment in the company from one or more venture capital firms, in exchange for preferred stock of the company. In addition to receiving a preferred return like in a Series Seed Financing, venture capital investors also typically receive important corporate governance rights (such as a seat on the Board of Directors and approval rights on certain transactions). VC financing typically occurs when a company can demonstrate a significant business opportunity to quickly grow the value of the company but requires significant capital to do so.