TLDR:
– There are three main ways to raise capital for an early-stage company: selling equity, convertible debt, or venture debt.
– Equity financing is the most common way to raise capital, especially when a company is at a stage where its valuation can be determined.
– Convertible debt is often used when a company is between round inflection points and a valuation cannot be determined. It provides a way for current shareholders to avoid dilution and buy time to validate a higher valuation.
– Venture debt, which is typically set up as a credit line, is preferred for larger and longer-term debt financing. It is generally provided by a venture bank coinciding with a major investment round.
– Companies need to be careful to monitor their financials and bank covenants to avoid falling out of compliance, as this can lead to their credit line being turned off.
– The number one rule for every startup CEO is to never run out of money, so careful cash flow management is crucial.
Investor and entrepreneur David Gardner discusses the different financing options available to startups and the benefits of each. He explains that there are traditionally three primary ways to raise capital for an early-stage company: selling equity to investors, contracting with investors for a note that will convert into equity in the future, and approaching a venture bank for debt financing.
Gardner states that selling equity is the most common way to raise capital when a company is raising significant funds and is at a stage where its valuation can be appropriately determined. However, he notes that between round inflection points, it can be difficult to determine an appropriate valuation, and so convertible debt is often used in this situation. Convertible debt is structured as debt with interest, which converts into equity at a discount when the company raises its next priced round in the future. This type of financing, known as “bridge” financing, is designed to cover a cash flow gap and buy the company time to reach the next valuation inflection point.
Convertible debt is appealing to founders because it is quick to set up and does not require setting a valuation. It also enables current shareholders to avoid unnecessary dilution and validate a higher valuation. Investors also benefit from convertible debt as it usually provides a discount on the next round, interest, and a not-to-exceed valuation for conversion pricing. Additionally, since the debt is usually secured by all of the company’s assets, note holders have priority over shareholders in a worst-case scenario.
For larger and longer-term debt financing, venture debt is preferred and is generally set up as a credit line provided by a venture bank. These credit lines often remain unused or minimally used but provide a safety net or slush fund for opportunistic acquisitions. The establishment of a venture debt credit line often coincides with a major venture capital cash infusion, as the banks are most eager to provide lending at this time. They typically require the company to use all of their banking services as part of the terms.
Gardner emphasizes the importance of minding bank covenants and regularly monitoring financials to avoid falling out of compliance. He warns that failing to do so can result in a company’s credit line being turned off, which can put the CEO and CFO in a difficult position with their board. He concludes by stating that the number one rule for startup CEOs is to never run out of money and highlights the importance of careful cash flow management.
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