June 5, 2017 | Jon Hautamäki
Common Funding Types for Early-Stage Startups
This article will be dedicated to presenting common funding types for early-stage startups, so that the next time you hear from an investor you met at Slush or Arctic15, you will hopefully have a basic idea of the funding alternatives.
Funding is an essential part of a startup’s further-development. If your startup has a very scaling business model, the growth of the startup will require hefty sums of good ol’ cash. In that situation, the best alternative is of course that the startup would be able to finance the growth with the on-going cash flow from business operations, with capital injections from the founders or simply just by bootstrapping. That way the founders can make sure that all the valuable equity and control of the startup stays in the hands of the founders. Only if those are not enough to enable the proper growth of the startup, should the founders start to seek alternative ways of funding.
If your startup has managed up until now to grow without external funding, your first external funding round will certainly be confusing as there are several different funding types to choose from. You got your equity financing, you got your debt financing and, as a cherry on top, you got your mezzanine financing, which is a sweet mixture of equity and debt financing – in the end, the correct funding type should always reflect the particular needs of your startup and the milestones you hope to achieve.
We will below explain in an understandable manner the various funding alternatives, as in the end the startup founders should always have a clear understanding of the common funding types as they are the ones who will have to develop their own fundraising strategy and vision.
As mentioned above, the main types of startup funding are divided into equity and debt funding.
Equity funding, as the title implies, refers to financing your startup in a way, in which you receive money in exchange for issuing shares of your stock. The startup can either give existing shares or issue new shares to investors. The common alternative is that investors are issued new – often preferred – shares in exchange for their investment. The issuing of preferred shares means that, in addition to the common shares of the founders, a new share class of preferred shares is created. The preferred shares give the investors certain additional rights and control regarding the startup.
It is up to the founders to decide what kind of equity they are willing to give up, but the later the funding round, the more likely the founders have to give up additional equity. The first funding round is often the seed round, which nowadays can be further-divided into pre-seed, seed and second seed rounds. Seed rounds are often raised from private investors as well as business angels and most likely the founders will have to give up equity ranging generally between 10-25% in exchange for investments ranging normally between EUR 250k – 2M.
When it’s time for your startup to hit the big leagues and you are seeking larger investments, the dreaded VCs come to play starting with the Series A. Normally a typical Series A ranges from EUR 2,5 – 5M in investments in exchange for at least 25-40% of equity in your startup. It is a big decision to take on board VCs, but then again, a VC can offer significant and much needed capital investments, which may take the startup to the next level.
After the seed rounds and the Series A, the next funding rounds are not hard to guess – please welcome Series B, Series C and so on. If you have struck gold with your startup and its business model, the equity funding’s grand finale will either be an acquisition or an IPO.
Debt financing is also a viable funding option for SMEs, but another question is whether it is in reality suitable for startups. In debt financing, the startup loans cash from various credit institutions and/or private investors. The startup will have to pay back the loans, regardless of whether or not it is making a profit.
Debt financing is, almost without exception, interest-bearing, which also has to be taken into consideration when thinking about the price of the funding.
Especially regarding startups, most credit institutions offering debt financing will require in exchange for the loan some kind of a collateral. The collateral is in place to make sure that the credit institution will get its money back – startups should be aware that banks will do almost anything to get their money back. As it is with casinos, the bank always wins.
It should also be emphasized that the collateral requirement makes the debt financing a challenging, if not an impossible, alternative for startups. Very few, if any, startups are in their early stages in possession of property that could act as collateral to a loan rendering debt financing to a secondary funding alternative for startups.
In order to make sure that your head is really spinning, let us present to you the sweet mixture of both equity financing and debt financing – mezzanine financing, which in our view brings together the best of both worlds. Mezzanine financing is a financing form consisting of various elements that traditionally has been connected to either the equity or debt financing model.
During recent years, a growing amount of startups have come to realize the value and flexibility mezzanine financing has to offer compared to the traditional equity and debt financing models. Mezzanine financing gives startups access to much needed capital without an immediate requirement to give up important equity to investors.
Mezzanine financing is normally divided into the following:
Subordinated loans given by investors to startups, which are considered as debt but treated as equity capital in case of loss of the equity capital (such as bankruptcy situations).
Convertible notes, which by now should be familiar to all startups that have raised their first funding rounds. A convertible note is an excellent and agile way of funding especially growth-stage startups. The convertible note is based on a written agreement between the startup and the investor giving the loan. In the agreement the startup and investor agree on the terms, which must be fulfilled in order to convert the loan into shares of the startup. In other words, the convertible note starts off as a debt instrument, but if certain terms are fulfilled, the original debt instrument is converted into an equity instrument. The convertible note is a very suitable instrument in situations where the valuation of a startup is challenging to determine. In that situation, the startup can raise a convertible loan from the investor and when the valuation of the startup has clarified, the loan can be converted into equity of the startup. As the investor has got an opportunity to convert the loan into equity, the costs of the loan are in general lower compared to normal loans meaning that the interest of the loan is more startup-friendly.
SAFE-instrument, or Simple Agreement for Future Equity. It has slowly reached even the shores of Finland and it is no surprise that the origins of said instrument is the US and A, the promised land of unicorns. With the SAFE, the investor, through a simple one-document agreement, makes a cash investment in a startup, but gets shares of the startup at a later date, in connection with a specific event. A SAFE is not considered as debt financing as such (more like an option in accordance with the Finnish Companies Act), but in lack of a better categorizing, the SAFE is a form of mezzanine financing. The startup and the investor need only to agree on a valuation cap and the date when the investment is converted into shares of the startup. This means, for example, that no interest is paid to the investor and as the SAFE can be agreed on with only one document, the startup is able to receive investments in no time with minimal transaction costs (i.e. legal costs).
Another similar alternative to a convertible note or the SAFE is an option loan, which gives the investor giving the loan, in addition, an option to receive shares of the startup for an agreed price.
Also worth mentioning are profit sharing loans, in which the profit that is paid to the investor is dependent on the profit the startup is making.
Mezzanine financing enables the founders to retain the ownership of the startup meaning that it is a more flexible and founder-friendly alternative compared to traditional equity financing. Especially the SAFE discussed above is a very interesting new form of mezzanine financing with its flexibility and speed, whereby it has the potential to become the uncrowned king of the world of mezzanine financing.
It is worth mentioning that to investors various forms of mezzanine financing can be riskier as mezzanine financing is considered a mixture of both equity and debt financing. That means that if the startup would for example go bankrupt, the investor that has given mezzanine financing would not get back any money before all “official” debts of the startup has been paid. Especially if your startup is in the early-stages, certain investors are not interested in offering mezzanine financing – or at least, not until the business model has been proven and the risks of investments are lower.