Understanding the basics of early-stage financing for startups

Many emerging growth companies will need to raise outside capital at some point in their development. Investors may also have questions about how investments in these companies are commonly structured.

The following is intended to provide a brief primer to common structures and terminology used in early-stage emerging growth company financings.

Friends and Family Financing
This refers to an investor group rather than a set amount or structure of financing. In short, it is an investor group sourced from an entrepreneur’s network at, typically, a very early stage of development. It could be structured as an equity financing, unsecured loan, convertible note or a SAFE (see below). To avoid misunderstandings and facilitate future financing, it is essential to ensure this type of financing is appropriately documented.

Seed Financing
Like a friends and family round, there is no hard and fast rule as to the size of the structure of a seed financing. Seed financing is generally understood as a company’s first transaction, including investors regularly investing in emerging growth companies. This could mean an investment from angel investors, an angel group or even a venture capital firm.

Convertible Note Financing
A convertible note financing is an interest-bearing debt instrument that is typically unsecured. It is intended to convert into equity at a later, specified event, typically a subsequent equity financing round of a specific size. The conversion feature will typically carry a discount that can be structured as an absolute discount off the price of the equity round, a valuation cap, or both. This relatively simple and flexible financing instrument defers discussions around valuation and control until future financing.

SAFE Financing
A SAFE Financing, or financing closed on a Simple Agreement for Future Equity, is a standard document used in early-stage financing rounds (like a Friends and Family or Seed round). It is not debt or equity. Instead, it is simply a promise that upon a future equity financing round or other specified trigger event, the investor will receive equity in the company (typically at a discount). Like the convertible note discount, the discount for a SAFE can be structured in various ways — typically as an absolute discount off the price of the equity round, a valuation cap, or both.

Series A Financing
These transactions will generally include venture capital funds that seek to acquire 20-40% ownership in the company. A lead investor will negotiate the term sheet and the legal documents and conduct due diligence. It will be structured as an equity investment (see Equity Financing below) and generally include economic and control terms.

Equity Financing
Equity financing involves selling a portion of a company’s ownership (i.e., the equity). Equity financing will generally include negotiating several economic and control terms, including board representation, voting rights, liquidation preferences and anti-dilution adjustments. Equity financing can be designated as a Series Seed or Series A financing. No defined amount will be raised in a Series Seed or Series A financing.

Registration Exemption
It is important to note that in the United States, the general rule is that if you want to sell securities in your company, you either need to register the offering with the Securities and Exchange Commission or rely on an exemption from registration, which, in general terms, typically requires restricting a securities offering to accredited investors.

While various structures can be used to finance emerging growth companies, one unifying theme is that it is always important to ensure that whatever structure is adopted is appropriately documented.

Editor’s note: Dan Wilcox is a corporate and deal lawyer in Bentonville. He can be reached at [email protected]. The opinions expressed are those of the author.