To raise capital, startup founders can approach:
- Governments for grants;
- Consumers for pre-sales of their product; or
- Investors for financial contributions.
This article focuses on the third option, financial contributions from investors. Typically there are three things that founders can offer in exchange: equity, a discount rate for equity at a future date, or a debt obligation.
Under corporations law, it is possible in certain circumstances to issue equity to friends, family and fools, people associated with the business, and well-informed investors. However, it is a fairly effort intensive process. In part, this is because issuing equity is highly regulated. The rules are quite complicated. For example, there are statutory limits, set out in full in the Corporations Act 2001, related to:
- Who your startup can issue equity to;
- In what amounts; and
- Over what time periods.
Also, you will need to manage the relationship between founders and investors, preferably with a suite of documents. These can cover matters from shared control of the company to the classes of shares issued to an investor, both of which can impact voting rights, dividends and payouts if the company is sold.
2. A Discount Rate for Equity at a Future Date
Sometimes an investor will transfer money to a startup during its early, high-risk stages. In exchange for accepting this early risk, the investor will receive shares at a discount relative to later investors. A convertible note is a legal instrument used to enable this arrangement whereby money “converts” into equity at a later date upon further investment.
The discount can take the form of a discount rate or a capped amount. The discount rate is a percentage discount on the sale price of shares to later investors. The capped amount is set at the time of the initial transfer from the investor. This cap limits the final amount paid by the investor for the shares and is not dependent on how well the startup performs.
A convertible note is a particularly useful financing tool for the following reasons:
- Overcomes a potential deadlock where founders and investors cannot agree on the value of shares of the company, which can be especially difficult in the early stages of a startup’s life;
- Is less complicated to draft than a suite of startup documents to bring an investor shareholder into the startup; and
- Enables founders to maintain control of their startup during early stages.
3. Loan Obligation
You can approach investors or banks for a loan to pursue your startup dream. Most investors require security for the loan such as a personal guarantee, which can put a founder’s personal assets at risk. You will also require sufficient cash flows to repay your loan, or else possibly lose your personal assets.
Questions about obtaining finance from investors for your startup? Get in touch on 1300 544 755.