Recently, we talked about the 5 most important things startup founders need to know before raising capital. Now we will go into detail and look at three ways to fund your company.
Startups need money to grow, therefore they need funding. There are only three financial instruments that make up your toolbox for classical private fundraising. Learn about them from Tienko Rasker, Leapfunder’s CEO.
A loan is an advance of cash. The person that gives a loan wants that cash back with interest on a predictable timeline. If you don’t have a predictable income, that means you’re very high risk for the person giving the loan. If you don’t have any collateral, you’re an even higher risk. Usually, startups are such a high risk for the person giving the loan, that they are not eligible.
Nonetheless, loans sometimes happen. A couple of reasons loans can be given to startups are:
a) the loan is a subsidized loan, meaning the government is taking the downside risk and
b) the loan might be a divert payment of a bill, so you owe someone money for services in the future.
In both cases, a loan is still dangerous. Eventually, you have to pay it back. And if there is a sudden cash out because of a loan repayment, it can topple your company. Try to make sure that at any moment you wind up owing someone, you have a good repayment scheme so that you can pay it back over several years.
Shares are the most familiar way for funding startups. You sell a percentage of the profits and a percentage of the voting rights to the investor for cash. Although selling shares is common, please remember that it’s always cooler to sell your product than it is to sell your shares. Eventually, you will run out of shares to sell, while you can always make more of your product.
Unfortunately, to do a share transaction, you need to have an exact idea about your share price. Usually, for the first one to three years of a startup’s existence, they aren’t able to come up with good evidence to support the valuation. That means the valuation is a blind guess, which makes the share transaction dangerous for the company. If the share price is way too low, you have given up a percentage of your company that’s too high. If the share price is way too high, you are creating problems for the future. Future investors will see the high price and refuse to invest at that price. That means you would have to lower the price of your shares (with respect to the earlier round) causing resistance and reluctance amongst the existing shareholders. It may sound strange but a significant over-valuation of the shares at any point in time can do a lot of harm, and ever cripple your company.
A convertible is a way of investing in shares without using a valuation. It’s the most popular way of investing in startups early on in major innovation hubs, such as Boston and San Francisco. A convertible is a share transaction, but the investor and the startup agree to a postponed valuation. The valuation is postponed until the first big cash investment in shares, on an agreed share price.
As soon as that big investment takes place, you can put a value on the shares and give the investors the shares at that price. You also give the convertible investors a substantial discount on the share price to make sure they get rewarded for the risk they took by investing earlier. Normally, there is a maximum share price that the convertible investors are expected to pay for the shares: it’s called the cap. So if the share price after discount is still higher than this capped price, the capped maximum price prevails. The discount and the cap together make the convertible an attractive investment.
To learn more about the most important things startup founders need to know before raising capital, stay tuned for the next article by Leapfunder!