Early-Stage Financing and Convertible Notes

I often encounter first-time entrepreneurs arranging their first round of outside capital. More often than not, this is the friends and family round of financing (Often called the friends, family and fools round of financing). In fact, for most non-tech startups, the friends and family of the founding team will be the sole source of outside financing.

The friends and family round is popular among entrepreneurs because of the difficulty of raising outside capital for founders without a proven track record of success. In addition, those closest to a founder are more inclined to invest because of their belief in the talents of a founder irrespective of the product, idea, competitive forces or investment terms.

The friends and family round of financing can become quite ticklish because of the simple fact that most startups do not succeed. Most people are not comfortable losing the money of their nearest and dearest. In order to mitigate potential conflict, it is highly recommended that founders who accept friends and family funding clearly communicate the risks of investing at the most precarious stage in a venture’s lifecycle. It is also highly recommended that a founder only accept investments from those people who can afford to lose the entire investment amount in a downside scenario. These two precautions will make it easier to maintain valuable relationships if the investment does turn south.

Like most complex (legal) questions, the answer is, “it depends…” The high end of the range should be about $250,000 to $500,000. As to the exact amount that is right for any particular venture, it should be driven by the venture’s long-term capitalization plan. It is sensible for companies to raise sufficient capital to get it to its next significant hurdle that will increase its valuation. For most ventures, this would be the launch of a prototype or minimum viable product.

The most uncomfortable and contentious conversations surrounding a friends and family round of financing is the issue of price (i.e., the present value of the enterprise). Teams of investment bankers and accounting professionals more often than not miss the mark on valuation in acquisition transactions. So how should an entrepreneur value their business accurately while leaving enough value on the table for their loved ones taking the biggest risk? Remember, this is a period in the life of the company when there are likely to be few tangible or intangible assets; very little, if any, revenue; and no market validation.

Getting the valuation wrong at this stage can have long-term consequences to the company and its investors. If the company is undervalued, the founders will give away too large of a chunk of the company to outsiders. If too much of the company is sold and the founding team holds too little of the company’s equity, sophisticated angel and institutional investors will be turned off. The founders, on an individual basis, not having enough financial incentive to stick with the company for the long run, may trouble these investors. On the flip side, overvaluing the company may mean doing a down round in the future that would dilute or even washout your initial investors via dilution. Pricing issues are further complicated if stock options (or other equity-based incentives) are offered to employees and common shares or units are offered in this round of financing. Hence, it is also important to consider the impact of the price in the context of the company’s long-term capitalization strategy.

As a rule, founders should keep the capitalization structures of their companies as simple as possible, for as long as possible. Convertible notes are the best way to accomplish this in most startup situations [1]. According to venture capitalist, Fred Wilson,

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

The benefits to the issuing company are numerous. The overall legal costs of issuing convertible debt is lower than other forms of venture financing. This is true even when one takes into account the multitude of document standardization initiatives in existence. In addition, the speed of closing a convertible note transaction is faster from both the legal and business perspectives. This is because the legal documentation is straightforward and there are, relatively speaking, few business points to negotiate. The latter is largely because the parties agree to allow the institutional investors to set the deal terms at a Series A round of financing. The benefits to the investor are enjoying the upside of a successful future exit, knowing that the money they are investing will not flow directly out of the company in the form of legal fees and, most importantly, avoids contentious pricing negotiations.

The failure to comply with securities laws when fund raising can have significant consequences. For this reason, it is important for founders to be aware of the applicable securities laws and the available exemptions from registration under the United States Securities Act of 1933 (the Securities Act). Regulation D covers the most common exemptions available to small companies. Offerings conducted under Rule 506 of Regulation D are the most common form of a Regulation D offering. Rule 506 requires that the issuer offer the securities only to pre-existing contacts that are accredited investors. It prevents the issuer from engaging in widespread advertising or communication of the offering. However, Rule 504 of Regulation D allows offerings of less than $1,000,000 (over a 12-month period) and allows such offerings to be made to non-accredited and non-sophisticated investors so long as the company is not subject to any reporting requirements of the Securities Act. Like Rule 506 offerings, offerings conducted under Rule 504 cannot make general solicitation.

In addition to federal laws, offerings must comply with state Blue Sky Laws. Federal laws preempt the regulation of Rule 506 offerings. This is not the case with Rule 504 offerings. However, in the case of Rule 504 offerings, New York provides an exemption for offerings to forty investors or fewer.

Do you need help navigating the world of early-stage financing? If so, please feel free to contact Michael G. Salmon, a partner at SalmonLaw, by clicking here. Setting out a simple capital structure that provides a foundation for future rounds of growth capital can mean the difference between life and death for early-stage financing. We would be happy discuss the issues raised in this article or any legal other issues you may have.

Now get innovating!

[1] In my next article, I will explore the mechanics of convertibles notes in more detail.