“Structure” is a term you’ll hear used by finance folks as you start hanging out more with those banker types. It is just a fancy way of saying the mix of debt and equity a company uses to finance its operations. It is important to understand these forms of financing when evaluating fundraising options for a startup. The mix of debt and equity a company uses will vary based on the maturity of the business, underlying economic conditions, founder preferences, and a host of other factors. There is no right or wrong structure…only options to evaluate based on your unique circumstances.
While there are additional, more complicated instruments than the three types listed below, I will stick to just the types of financing the typical startup founder will likely encounter during early-stage and growth-stage fundraising.
Debt Financing
As you can probably guess, debt simply refers to borrowing money to fund your business operations. Debt can come from many sources, including banks, non-bank lenders, private investors, and occasionally even vendors or strategic partners. Non-bank lenders, such as Pipe.com, are becoming an increasingly popular funding source for startups.
Debt is characterized by its terms. With debt, you are borrowing money from a provider with the understanding that it will be paid back over some fixed time interval and at some pre-set interest rate. Debt is also distinguished by its having preferential rights above equity.
Types of Debt:
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Preference:
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Senior:
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The most senior debt holder is the highest preference holder in terms of liquidation. In other words, this is the investor that gets paid back before anyone else if the business is liquidated. Typically the bank.
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Subordinate:
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Any debt that is repaid only after the senior debtors are paid. Accordingly, it is riskier and thus naturally more expensive.
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Security: [regardless of preference order]
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Secured, Non-Recourse:
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Debts that are backed by the business’s collateral such as equipment, inventory, AR, or other current assets are considered “secured.” Non-Recourse means that the debtor only has rights to the specific collateral pledged and cannot pursue any other assets if the collateral is not enough to satisfy the loan obligations.
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Secured, Recourse:
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Same as above, but lenders of recourse loans may still go after a borrower’s other assets if, in a liquidation event, they have not recouped all of their capital from the pledged assets.
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For founders, this often means the addition of a “personal guarantee.” Providing a personal guarantee means that you assume personal responsibility for the balance if your business becomes unable to repay the debt.
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Unsecured:
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Any debt that is not backed by any specified collateral or guarantees.
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Advantages:
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Typically less expensive than equity
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No ownership dilution / control
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The relationship ends once paid off
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Predictable impact on cash flow
Disadvantages:
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Typically have strict underwriting requirements
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Typically impose covenants or controls over business activity for the term of the debt
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Can open up the founder to personal liability if providing a personal guarantee
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Less flexibility on capital repayment timing
Equity Financing
Simply put, equity represents the value that would return to shareholders if all the assets were liquidated and debts paid off. In fundraising, we typically use the term equity to refer to a shareholder’s degree of ownership or “stake” in a company. When you raise funds through equity, you are selling a stake of ownership in the business in exchange for capital. Most people think of equity financing when they think of raising money to fund a new business venture.
It is crucial to understand that equity financing is just that: a form of financing, And it is an expensive form of it. It is not free money. Unfortunately, it is pretty easy for first-time founders to approach it as if it were. However, if your business ends up wildly successful, equity financing will have proven to be the most expensive form of capital.
While expensive, it is often the best source of capital for early-stage ventures as you have more financial flexibility to operate the business. It is also the only form of money typically available to early-stage companies that cannot meet the stricter underwriting or covenant requirements of debt providers.
Types of Equity:
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Common:
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Common stock represents a simple ownership stake in a business. In startups, this is most often the type of equity that founders and angel investors hold as well as the type of equity early employees are given access to via stock options.
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Preferred:
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Preferred stock represents a “preferred” class of ownership stake in a business with a higher claim on dividends or asset distributions than common holders. Essentially, preferred stock means that the holder has preferential rights to get paid back their capital (or some multiple of it) first – before anything goes to the common holders. Normally, preferred only matters in a downside event where the company didn’t perform as well as everyone expected. This is the typical structure of venture investments.
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Participating Preferred:
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A type of preferred stock that includes additional dividend payments. Most expensive form of equity and has fallen out of favor / not very common. If you have a participating preferred term sheet, then things have not gone well, or you’re not talking to the right investors.
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Advantages:
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Most accessible form of startup financing, more tolerant of risk
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Fewer and more liberal underwriting requirements
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Less strict operational covenants
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Preserves liquid cash for business operations due to no repayment requirement
Disadvantages:
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Give up some percentage of ownership in the business / dilutive capital
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Typically the most expensive form of financing
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Investors may require governance rights
Convertible Debt Financing
For startups, convertible debt (often referred to as a “convertible note”) has become a popular mechanism for quickly accessing temporary capital between equity fundraising rounds. Convertible debt is a form of hybrid capital that combines some aspects of both debt and equity. Though technically a debt instrument, most people view convertible debt as unpriced, deferred equity.
Essentially, convertible debt is an unsecured note that converts into stock at the next equity fundraising round but at some discount to that round’s valuation. It is structured as a debt in that there is a defined interest rate and term (usually 12-24 months). However, the interest typically accrues over the period of the note, and no principal or interest is paid during the term. However, a “SAFEs” (Simple Agreement For Equity) have become increasingly popular as an alternative to traditional convertible debt and do not typically accrue any interest.
Both the company and the investor are operating under the expectation that the note (or SAFE) will be converted in an upcoming equity round before the note’s maturity. Neither is planning on the note to be repaid at maturity (this is simply downside protection for the investor, though not a great one). Instead, the investor gets the benefit of not having to do the hard work of valuing the equity in the business today and can instead piggyback on a future investor’s due diligence while receiving a discounted price to that paid by said future investor.
Use Case:
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Let’s say you’re planning to raise a significant Series A (say $20M) to scale up your startup. However, as you burn through your seed capital, you realize you ideally need another 3 to 6 months of runway (say $2M) to get some additional validation, such as a significant customer account. Doing so will significantly boost your prospects in the Series A.
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As an investor, I have the relatively small amount of money you need now and believe in your business, but I don’t want to do the hard work of figuring out how to value your company for such a small check size. So I instead structure the investment as a convertible note.
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When you raise your Series A, my $2M will “convert” into stock but at a pre-determined discount to the price paid by the Series A investor.
Advantages:
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An excellent way to “bridge” equity funding rounds and avoid down rounds or less favorable equity fundraising conditions by extending the operating runway
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Speed: Due to the straightforward, familiar structure of convertible debt, it is typically much faster to raise than a traditional equity round
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A cost-effective source of capital compared to down rounds or more predatory equity financing.
Disadvantages:
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Same as equity assuming conversion. Otherwise typically treated as senior or subordinated unsecured debt (depending on existing capital structure and note terms).
