Four types of investment tend to be more common for young companies, and this article takes you through them. As ever, context is everything and no one type is better than the others absolute of the company’s situation.
Simple Equity
An investor gives you money, and receives back shares in the company. These are new shares in the company, issued to the investor for that money, which means it is possible to calculate the entire value of the company at this point.
Because new shares are being issued by the company, it is the company that receives the money, to be used for company purposes. This is different from someone buying shares from a founder, in which case the founder is simply selling their own shares for personal profit and can use the money as they please.
An equity investment is the most common form of investment from friends and family, angels, and funds. An equity investment is a valued round, as the company has a value placed on it. As a general rule you don’t want to value your company too high in an early round because a “down round”, in which a later round gives the company a lower valuation, can be very difficult to raise.
With their equity, an investor will obtain certain rights and risks. An immediate theoretical risk is that you could wind up the company the day after receiving the money. For example, if someone put in £1m for 25% of your company, the company is worth £4m and the founder has 75%. Upon winding it up, the investor could walk away with £0.75m the next day.
To prevent this happening, there will usually be terms in the investment agreement to prevent this. One possibility is a right to first money for the investor, under which they get their investment back before anyone gets a share, regardless of when the company winds up. If it is sold for more than £4m one day, this will make no difference. This right may be expressed as a clause in the contract, or through issuing a different type of share.
Another method that investors frequently use is to take a board seat with a veto. For positive voting they have no unusual rights, but they are able to veto anything proposed by other board members- including winding up or distributing company money to shareholders.
Usual equity stakes for investors in startups, funding Seed or Series A rounds, are 10-30%.
Clawback
In some cases, an investor will feel that a company is very risky in its early days, but could do very well if it survives that early period. To mitigate against this risk, the investor takes a very large share of the company, so that if it fails early on the investor can salvage as much money as possible.
However, this large equity stake is unfair if the company does well; so, against certain milestones, the founders will claw back equity from the investors to the point that the successful company rewards both founders and investors fairly.
Clawback can be seen as bringing unnecessary complexity to a term sheet early on, and it can bring capital gains issues for the founder; the new shares issued each year may be treated as capital gains, and so something will need to be worked out at the beginning to prevent a founder having tax bills larger than their salary.
If a company needs to raise a very large sum for its first raise, or will have a long time until the product is ready, then it will carry more risk for investors and so a clawback mechanism may be necessary to get funded at all. Otherwise, the negatives outweigh the positives.
Debt
A provider of debt to a company is an investor in that company. Debt is different from equity in a number of ways, but the key ones from a funding choice perspective is priority.
Priority means that debt must be paid back before equity owners receive any money. Therefore, having debt can make a company less attractive to equity investors, as the value of a company when sold will have to be reduced by the amount of the debt, and until then there will be repayments (interest) deducted from annual cash flows.
Security is often required for debt. If you don’t pay me back, what do I get to make up for it? Larger companies have their revenues, assets, inventories and other things that debt providers might use as security. Even their shares may be seized in the event of non-payment.
Smaller companies often don’t have these things, and so debt is often either impossible to get, or comes at a very high interest rate. Usually, the founder will have to use their own house as security (don’t do it).
The other issue that usually makes debt a bad idea for young companies is that debt has fixed cash flow requirements. However a good or bad year a company has, it has to pay its debt. Young companies often have volatile earnings and profits, and frequently aim to have profitless years as they grow. Debt puts these companies at risk of financial collapse, even though they may be doing well from a business sense.
Convertible Loan
Accelerators and incubators mostly use convertible loans to offer their funding. There are many types, but a common one is for money to be given to a company as a loan and in exchange, when the company next has a valued round, the loan turns into equity- it converts.
Some details: The loan has no payback period or interest, so is different from debt as discussed above. The amount of equity it converts to is pre-agreed before the money is given. A valued round can be an equity investment later on, at which the company is valued because equity is given for money, or it could be a sale, in which the company is valued, or an IPO.
For example, a company might receive a convertible loan of £50k for 10% from an accelerator. It’s just a loan so there are no long contracts or negotiations, and the company has no obligation to pay interest. The company also has no fixed value right now, so there is no need to argue about what it might be worth.
A year later the company might receive an investment of £1m for 25% equity. The loan converts at this time into shares- 10% of the equity to be precise, as agreed in the loan. This leaves the investor with 25%, the accelerator with 10%, and the founder with 65%.
A common form of convertible loan used in America is the SAFE, or Simple Agreement for Future Equity, built by the Y Combinator. These can have different mechanisms to reward the investor without burdening the company, including valuation caps and discounts. A good explanation of SAFEs can be found on the YC website, or on this external article. They are not yet very popular in the UK, but hopefully will become so as they provide a very efficient way of getting capital flowing into young companies.