Early stage finance is an arcane topic upon which volumes have been written. For the uninitiated entrepreneur, the process of raising investment capital is rampant with the potential for disappointments, disputes and misunderstandings. In this series, I will present four rules of thumb (or "heuristics" for you VC-types) to keep in mind as you raise money.
Rule #1: Know The Difference Between Debt and Equity
For starters, it is essential to understand the differences between types of investment capital. Debt is a fixed obligation to repay a sum of money at a stated maturity date for which an interest rate is charged. Equity in its purest and simplest form is an investment of money with no fixed return but with a theoretically unlimited potential return because it represents the residual value of the enterprise after the repayment of debt.
Debt is non-dilutive. Assuming no equity "sweeteners," creditors do not own any part of the residual value of the company once they are repaid. But, generally speaking, creditors must be repaid (with interest) before equity holders are entitled to anything.
So there is no free lunch. Either you accept the obligation to repay the money you have borrowed or you accept a part¬ner into your business that owns equity in your company.
But, let's dispense with the generalities. In reality, most early stage enterprises are not sufficiently creditworthy to obtain debt in the pure form I just described. Nor are founders apt to pledge personal assets and/or give guarantees to secure corporate debts. So equity or equity-like investments are the only real form of private capital available to emerging businesses.
An example of an equity-like investment masquerading as debt is the famed convertible note.While facially these securities have the appearance of debt because they refer to a principal amount, an interest rate and a maturity date, in actuality they operate very differently than traditional debt. Early stage note holders are not looking for the fixed returns offered by debt, but rather for the "home run" returns of successful early stage investing.Therefore, periodic principal payments are rarely, if ever, made and interest is accrued and capitalized rather than paid in cash. Moreover, early stage companies usually do not have adequate tangible collateral to secure the repayment of the notes. So the protection afforded the note holders in a default or liquidation scenario is negligible.
The principal virtue of using convertible notes is that unlike pure equity investments, they facilitate a quick closing without the parties having to agree on the valuation of the company. At the same time, they provide priority and protection to the holders vis-a-vis the stockholders – albeit of marginal value. Note financings priced against a subsequent round transfer the valuation decision to those investors with the comparative advantage in making it – the VCs. VCs have far greater access to information regarding market conditions and valuation drivers than most angel investors because they see many more transactions in a given market space. The risk to the note holders, of course, is that they cannot be assured that the subsequent financing trig-gering their conversion into stock will take place during the term of their note, if at all – pot luck, so to speak.
Originally published August 13, 2014
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
