The Plain English Guide to Equity Financing
What is Equity Financing?
Equity financing is a type of funding that allows you to sell shares of your company to investors. You receive the capital to grow your business and investors get partial ownership of your venture. In equity financing, investors might receive common shares, preferred shares, or the same voting rights and treatment as founders.
We’ve all seen the headlines, read the stories, and believed the hype. But what does it really mean to land financing for your startup? How does it work? And most importantly how do you actually do it?
This guide will walk you through the types of financing structures, the basics of financing rounds, and an overview of the fundraising process. It can feel like a long road to secure investment for your startup, but with the right knowledge, you can make it.
Debt vs. Equity Financing
Equity financing means you’re selling shares in your company to investors. You get the capital needed to grow your business and the investors walk away as partial owners of your venture. They’ll receive common shares, preferred shares, or have the same voting rights and treatment as the founders.
The only difference here is that preferred shares usually earn back their money in the event of an underwhelming exit event. An exit event happens when you sell your company, and an underwhelming exit is when you sell the company at or below the valuation the business had on its last financing round.
In these cases, preferred investors are protected and common stock is awarded from whatever is left. The main characteristic of selling actual stock is the need to have a share price or valuation on the company.
Unless your early-stage startup is generating significant cash flow, you won’t be able to walk into the local bank and receive financing. This is where venture debt can help new companies.
Debt financing allows you to take a line of credit based on your revolving revenue or accounts receivable. This type of financing is most commonly seen in later-stage companies. If you are a pre-revenue company, there is another type of debt to consider: Convertible notes.
A convertible note is debt intended to be converted to equity at a later date. It has a principal (the amount invested in the note), interest (just like any debt instrument), and a conversion cap (the maximum valuation you can have on the business). The conversion cap is designed to protect current investors from founders raising more money at a very high valuation — essentially, it’s the most they’ll pay per share at the current round.
But what happens when convertible notes don’t match the intention of investors who want to own a stake in the company without agreeing on the valuation? That’s where a simple agreement for future equity (SAFE) can help.
A SAFE is not a debt instrument and guarantees the investor shares in the company at a future date at an agreed upon discount. SAFEs can include interest and caps, similar to notes. You can find sample agreements free online via Cooley.
Types of Funding Rounds
The initial funding a company takes for its founders to go all-in on the business and get the product off the ground. These rounds generally don’t make headlines. It takes hundreds of thousands of dollars to get a business going. This usually comes from friends and family or the founders themselves. This round will often rely on equity financing or a convertible note.
These rounds typically range from 500K to 2 million and are usually a priced equity round. This is the first time institutional investors or VCs get involved with new startups, and founders should expect to give up a board seat at this stage.
These rounds generally raise between 4 and 10 million dollars and are the first time preferred shares are offered. Expect a formal board to be installed, if it hasn’t already happened. Your investors will also want you to have a healthy option pool.
Contrary to what you read on TechCrunch, not every startup’s path is roses and sunshine. Sometimes, you don’t hit your numbers and need to pivot. This is where bridge rounds come into play. Bridge rounds enable you to raise a small round — usually on convertible debt — to avoid raising a true round at a low valuation. Bridge rounds are often led by existing investors.
Wondering if your company meets the criteria to raise one of these rounds? Take a quick look at some back-of-the-napkin math to ensure you’re on the right track.
The Term Sheet
When your lead investor gives you a term sheet, things get serious. This is where you’ll find out what your investor’s words are worth. The main components of a terms sheet are:
- Valuation – The valuation is what most founders grab onto right away. How much is your business worth, pre-money (before the infusion of capital)? You can negotiate this point, but some firms are definitely valuation sensitive and searching for a good deal.
- Board seats – Term sheets can dictate board formation and require certain seats for certain shareholder types. For example, a seed stage term sheet might require the formation of a three-person board with common shares voting for one director, the lead investor voting for another, and a neutral third party from the industry for your final board member.
- Option pool – The number of available stock options you can grant to team members. If your available option pool dips below low double digits, you must replenish it. The number of outstanding options is used when calculating your value per share.
Value per share = (pre-money valuation) / (common shares + preferred shares + total options)
The investor will always want you to readjust the option pool before investing. So, the price-per-share is usually adjusted down before the investor puts in their money. This is another term sheet component that impacts valuation.
- Preferences – Preferences allow the investor to specify the types of shares they want and what those preferences mean. The main type of preferences used today are “convertible preferred.” This means the investor has the option — in the event of a liquidity event — to take their percent stake in the company with common shareholders or receive a payout of a 1X multiple on the money they’ve invested before anyone else gets paid out. This is meant to protect investors from small acquisitions.
- Legal fees – Usually, the investor passes legal fees to the company for diligence and document preparation.
The Investment Process
There are many good resources about what it takes to create an investor funnel. The main thing to note about the investor process, however, is it’s not a one-time event. You’ll need to get comfortable being knocked down and continuing to push forward. It may take 100 pitches, but if you have a process you can make it work.
What You’ll Need
Behind every good company are good materials guiding them on their journey to a successful raise. Here are a few resources you’ll need:
- Investment deck – You should always have a business plan PDF. Prepare a 10-20 slide deck (the earlier the round, the fewer the slides) that walks investors through the problem, your solution, the market opportunity, who else is in the space, and why your team is going to make waves with this business. Invest time in making your deck attractive. After all, if you aren’t willing to put the time into crafting a solid pitch, why should investors give you their time and money?
- Financial Model – Every company should have financials. These are the expense and sales projections for your business. Investors care about the levers driving your top line. Are you using inside sales? Outbound marketing? What are the unit economics of your business? Investors care about unit economics, because they want to see how your customer acquisition cost stacks up with your lifetime value (how much your customer is willing to pay you for as long as they’ll be your customer). Early stage companies have a hard-enough time predicting where they’ll be after one year, so no one will take you seriously if you have five-year projections.
- Cap Table – A cap table shows the equity positions of every equity holder in the company. It demonstrates how many shares each founder has and what’s been allocated to other investors as well as employee options. Investors want to see that the founding team has a significant stake so there’s a reason to stick it out through tough times.
To see what other companies use to raise their rounds, check out these free resources from Techstars.
What’s Right for Your Business?
Whether you go for equity financing, debt, or something in between depends on the outcomes you want to achieve with the business.
Are you comfortable having joint board decision making with an external investor? If not, look for more at debt or vet your equity investors more diligently. If you’re not interested in rapid growth, don’t waste time pitching investors. And if you want to create a product, the venture route can take you there.
Just don’t get caught up in the headlines. At the end of the day, the main determining factor of what makes a good financing round is you and your team. Onward and upward!