When it comes time to look for funding for your startup, each source has its own unique advantages and disadvantages. By understanding your options, you’ll be able to make make the best decision for your startup.
“There are quite a few different ways that you can go about funding a startup, but not all are created equal,” explains Adam Heitzman in an Inc.com post, “It’s important to analyze all angles of your business and your future goals and then analyze each type of funding opportunity so that you make sure you’re starting your business off on the right foot. One wrong move when it comes to finances and you could be back to square one.”
This post compares two popular funding types, convertible notes and equity. Keep reading to see the pros and cons of each.
Convertible Notes
Historically, convertible notes were used to raise smaller amounts of funding in between larger funding rounds. These days, convertible notes are becoming more popular during seed stages, where startups may be looking to raise less and aren’t ready to part with equity in their company.
When closing a convertible note deal, investors agree to specific terms and when the next round of funding happens, the note automatically converts to equity at a discounted price (usually 20%). Caps can be added so if the company raises more than the amount decided in the original terms, early investors get additional discounts to make up for the dilution in the deal. If your startup doesn’t seek out any additional financing during the loan term, the convertible notes may either be turned into equity or become debt that you must repay.
Pros:
- Less expensive
- You don’t need to get a valuation
- Takes less time
- Investors aren’t involved in board decisions
- Have the option to pay back cash
- Part debt, part equity
- Angel investors and venture capitalists
- Terms of 6 months to 2 years
- Typically, no monthly interest payments
Cons:
- Smaller round
- 4-8% interest per year
- Caps can be complex (uncapped deals best for entrepreneurs)
- Debt can be hard for startups to repay
Equity
Of the two types of funding that we’re looking at in this post, equity is the more common. But, as I mentioned before, that might be changing. With equity deals you are typically looking to raise more money, perfect for high growth startups with more risk. Since equity investment deals are so much more complex than debt or convertible debt, it is recommended that you get a lawyer while you decide on terms:
“Once you’ve located a good source of cash, you’ll need to negotiate a fair deal. We really, REALLY recommend that you enlist legal counsel whenever you’re negotiating an equity arrangement. Yea, yea, we know – lawyers are expensive. But trust us, they’re worth it. Don’t skip this step!” urges a post on Grasshopper.com, “While it can be tempting to jump at the first offer you get (“this person is giving me cold hard cash – I’ll take it!”) the ins and outs of equity contracts can be complicated, and it’s important that you have an experienced professional looking out for your best interests, both today and down the road.”
This type of funding can be a little more difficult to obtain since you need to get a valuation for your startup. You also need to be willing to part with some ownership. Most investors want preferred stock with about 6-8% interest in the early stages, rather than common stock.
Pros:
- Don’t have to repay like debt in short term
- Raise larger amounts
- Benefit from investor expertise
- You aren’t liable if your business fails
Cons:
- 25 – 30% of company
- Need a valuation of your company
- More complex to structure
- Costly legal bills
- Takes longer to close
- Investors usually get some amount of board control
Conclusion
Making the decision between convertible debt and equity is really a situational one that varies from startup to startup. If you need to raise larger amounts and it is difficult to predict your future cash flow, you are better off going with equity. If you are an early stage startup looking to raise a smaller amount of you are in between funding rounds, convertible notes hold a lot of advantages.
To learn more about different types of funding available to startups, check out this post.
