STARTUP FINANCING 101: How to Finance a Startup

Table of Contents

Part A: Financing Basics

1. Debt Financing vs. Equity Financing
2. Dilution
3. Securities Law Fundamentals

Part B: Methods of Financing the Startup Company

1. Bootstrapping
2. An Equity Partner
3. Bank Debt
4. Friends and Family Loan
5. Crowdfunding
6. Accelerators/Incubators
7. Convertible Debt
8. Convertible Equity
9. Equity Financing/Priced Rounds

Part C: Startup Financing Steps

Step 1. Self-funding/Friends & Family
Step 2. Find Investors
Step 3. Convertible Debt (for raising $0 to $1M)
Step 4: Series Seed financing ($500k to $1M)
Step 5: Series A financing ($1M+)

I'm going to tell you how to startups are financed in a systematic way. People throw out ideas like: "Oh, you need to get VC financing." But people don't tell you when or how that fits into the overall structure of financing the company.

As a startup lawyer in Texas, I'm going to fix that. I want people to understand the general principles.

Here's an overview of how startups are financed.

Part A: Financing Basics

Startups are all about growing quickly. A process or system is established, money is raised, that money is used to expand operations, more money is raise, that money is used to expand more. Rinse and repeat.

Under this system financing is critical to the well-being of the startup.

So how is everyone doing this?

Here's how.

First, you have to have a working knowledge of debt vs. equity financing; what the hell dilution is; and the fundamentals of securities law. Then I'll tell you about the common methods of financing and how they work; and afterwards I'll tell you the sequence of events and how this all plays out.

1. Basics: Debt Financing vs. Equity Financing

I know that this is extremely basic information. But since I have seen entrepreneurs confuse this debt/equity concept, I'm taking a moment to clarify it. Trust me, if I didn't see people getting absolutely lost on this, I wouldn't bother.

There are two overarching methods of financing a business: debt and equity.

a. Debt financing

Debt has to be paid back, e.g., a loan.

Debt financing is not typically used in financing a startup

This is because straight debt does not correspond well with the profile of most startups. Most startups are young and not credit worthy; are looking to use funds to grow the company; and are high risk. Paying back creditors doesn't fit into that scheme.

b. Equity financing

Startups use equity financing to grow. This is THE way that startups are structured.

The startup company sells ownership shares of itself, e.g. stock of the company, to investors. Investors and shareholders make their money when the company gets acquired (or similar transaction) and the shares are sold after increasing in value.

Equity does not have to be paid back. If someone buys shares of your startup, the startup does not pay back that person the amount they gave.

If an "investor" gives money to the startup and that amount is not in exchange for shares and doesn't need to be paid back, that's something else entirely. That's called a gift and you should be thankful.

c. Hybrid Instruments

There are certain financial instruments that behave as both debt and equity such as a convertible note. More on this later in this article.

d. Financing for Texas startups

A lot of this material is the same regardless of jurisdiction. Financing startups in Texas is pretty much the same as anywhere else. The differences will mostly come down to other factors like ease of doing the deal, size, etc. Deal sizes in Houston, Texas and Dallas, Texas for clean energy tech companies or health/life sciences startups may be higher than elsewhere. The fundamentals are the same everywhere.

2. Basics: Dilution

Any time you do an equity financing, you sell some of the company to investors. When more people own the pie (i.e. the company) you're going to have less of a percent of the pie for yourself. That's just simple math. Dilution happens. You will not be able to avoid it. So what is there to do about that? Here's what you do. You control the process.

Here is a simplified example that ignores certain complexities but is designed to give you an overview of how it works.

Ex: You own 100% of your company. An investor buys 20% of your company, and then later another investor buys 15% of the company. What is the result of these actions?

After the first investment:

Your ownership: 100% x (100% - 20%) = 80%
Investor 1 ownership: 20%

After the second investment:

You ownership: 80% x (100% - 15%) = 68%
Investor 1 ownership: 20% x (100% - 15%) = 17%
Investor 2 ownership: 15%

So what happened? Everyone's percentage share of the company went down. Everyone got diluted. This happens any time someone receives ownership shares in the company.

There's more to dilution and I talk about that in another article on this site. But for now, don't worry much about dilution. Just get a good grip on the fundamentals of what I'm talking about for now.

3. Basics: Securities Law Fundamentals

Key Points:

A. Shares of stock of a company are securities. The offering and selling of securities is regulated.
B. Your startup needs to register the offering of shares or use an exemption from registration.
C. Make sure the investor is an accredited investor. PERIOD.

Bonus: Don't offer/sell securities unless you know what you're doing

Look, securities law can get complicated. Don't try to deal with it alone. Get some help. If you try to understand all of it, you will be wasting valuable time that would be better spent working on your startup and your system.

What I want you to know is the fundamentals so that you have some idea of what is going on and some idea of what you can or can't do.

A. Shares of stock of a company are securities. The offering and selling of securities is regulated.

Back around the early 1900s a bunch of assholes went around and swindled people by selling questionable and sketchy investments in companies.

Actually people were doing that way before the early 1900s, but around that time the government decided to do something about it.

The end result is that there is now a securities law framework that companies need to abide by in order to issue shares (i.e. securities).

B. The startup needs to register the offering of shares or use an exemption from registration.

A company cannot issue securities unless the offering of securities is registered with the Securities Exchange Commission (SEC) or there is an exemption from registration. Registration is an incredibly timely and expensive process and just not worth it for a startup to do. So instead of registering the securities, a startup uses an exemption.

Exemption Parameters

There are a whole bunch of exemptions that the government has carefully created that is available for companies to use. The government doesn't want to stop investments in companies. It just wants to make sure investments are being done in a safe and responsible way. For practical reasons, the only exemptions that startups actually use when fundraising is rule 506(b) and rule 506(c). Don't try to change this and skirt this idea.

Under these exemptions, a startup can raise an unlimited amount of capital under certain circumstances (e.g. an investor is an accredited investor--see below.) You cannot generally solicit the offering under 506(b), but you can under 506(c) You can read more about it here

Essentially the government is regulating the selling of ownership stakes of a company. The regulations are irritating to deal with (but are there for a good reason.) There are some exemptions that help make this process easier for companies to deal with. So carefully using those exemptions in order to not have to register is what startups need to do in order to do an equity financing. THAT'S what's going on here.

Yes, you need to abide by these rules.

C. Make sure the investor is an accredited investor.

One of the key components of the exemptions startups use when selling equity for financing purposes is that the investor (i.e. the person buying the equity) is an accredited investor.

Any time the startup is going to sell shares to someone, I want you to ask: is this person an accredited investor? If not, stop what you're doing.

Why? And what is an accredited investor any way?

The government wants to make sure that people investing in these small private companies are not unsophisticated investors. Again, the government doesn't want people getting screwed out of their money. The government is essentially saying: "Fine, we will allow people to invest in companies that don't register their stock with us. However, if someone is going to invest in these companies, we want to make sure that person is at least heads up and knowledgeable about how investments work (i.e. an accredited investor.)"

Here's what an accredited investor is:

- Any director, executive officer, or general partner of the issuer of the securities being offered or sold; or

- Certain business organizations with total assets in excess of $5,000,000; or

- High net worth individual: Individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000 (excluding primary residence); or

- High income individual: individual income in each of last two years of $200k+ ($300k+ joint with spouse) with reasonable expectations of that same income in current year.

For those that may be wondering, yes, 506(b) allows for 35 non-accredited investors, but the problem with this is that if you have any non-accredited investors, then the disclosure requirements are so burdensome and expensive, it's just not worth it.

So I don't care if it's your best friend and you've known him all your life, or if it's an uncle, aunt, whatever. The investor needs to be an accredited investor. There is no such thing as a friends and family exemption.

"But...but...but...I've known this guy all my life and I trust him and want him to have some shares of my company."

STOP.

Is this person accredited? If not, it doesn't matter. Do not offer securities to that person.

Or, let me put this another way: who needs to be an accredited investor when the company is doing a financing? Answer

Bonus:

Securities laws and regulations are complex. Don't mess around with them if you don't know what you're doing.

Part B: Methods of Financing the Startup Company

In Part A I covered the basic building blocks and fundamentals of financing a company. Here are the actual methods used.

1. Bootstrapping

Bootstrapping is financing the company in a lean fashion. The entrepreneur uses their own funds and internal funds of the company to finance and grow the company. This means not using external investments or outside help. Typically most brand new companies start off in this manner.

Why this is good

i. allows you to not have to listen to other investors (i.e. you can stay true to your vision);
ii. you keep in financial control of your company

Why it sucks

i. your personal funds to bootstrap might be severely limited
ii. you can't leverage

When you should use it

i. early in the startup
ii. when its your only option
iii. when you can create a very lean enterprise with a lot of potential for revenue

Make sure you do these things

___ i. If you're putting in a small amount of funds into the company, purchase common stock. You don't want to make the valuation of the common stock too high so only do this for small amounts of funds.
___ ii. If you're putting in a fairly large amount of funds into the company, use convertible equity with gentle terms

2. An equity partner

This is a similar to bootstrapping. An entrepreneur who has some skills may go out and find a partner who has complimentary skills as well as access to capital (money.)

Why this is good

i. having an equity partner allows you to bounce ideas off someone else

Why it sucks

i. it can be very difficult to find someone who you work well with

When you should use it

You should have an equity partner. If you can create something that shows a lot of revenue, then you might not need one. A lot of institutional investors won't fund startups with only one founder.

Make sure you do these things

___ i. GET IT IN WRITING. Look--people get upset. Stress runs high. Shit happens. Some times it doesn't even get that bad. People just get different ideas or want to do other things in life. Best to just get it all in writing at the forefront.
___ ii. go into business only with people you trust
___ iii. vest shares
___ iv. anticipate problems before they arise
___ v. have well drafted bylaws and agreements of the company
___ vi. have transfer restrictions
___ vii. assign IP. IP shouldn't belong to you personally. Don't let it belong to your partner. IP needs to belong to the company.

3. Bank Debt

The company goes to a bank, asks for money, and assuming all is well--the bank lends the company money.

Why this is good

i. allows the company to leverage funds

Why it sucks

i. for a fast growth company, debt can be a terrible idea as you need the revenue of the company to grow the company and not to pay back debt.
ii. can be difficult to secure a good amount of debt for a very young company

When you should use it

Straight debt is often not used by early startups for the reasons discussed above.

However, there are many companies that will have a reasonable revenue stream. For those companies, using a combination of debt and equity financing is a fantastic idea.

It is difficult to do this. The best I've worked with have mastered it to a T and are unstoppable.

Make sure to do these things

___ i. be cautious as to who is going to be responsible for the loan. Is it you, the company, someone else?
___ ii. explore other options before securing bank debt
___ iii. watch out for interest rates on a risky project.

4. Friends and Family Loan

This is like getting a loan from a bank except it's from friends and/or family.

Why would you get it from friends or family instead of a bank? Because banks won't lendt your young company money and the terms that a friend or family member can offer will be much more generous.

I've seen many companies finance themselves early on with money from friends and family. There is nothing wrong with this and its extremely common.

The amount of funds here can vary greatly. The best way to structure this type of financing is to document the dollar amount as a loan. Startups are risky and it is important to make clear to friends and family that this financing deal is risky and they probably won't get their money back. Remember what I said about managing expectations. If friends and family are going to splash in some serious cash then they should, assuming they are accredited, do it as a convertible note deal.

Why this is good

i. allows you to leverage funds

Why it sucks

i. friends and family may have unreasonable expectations
ii. they may want upside if the company does really well and sells off in an acquisition. They don't realize that the deal was actually a very gentle loan.

When you should use it

If you have access to a rich friend or family, and they want to loan you money AND they understand it may never get paid back--then go for it.

Make sure to do these things

___ i. if your friends or family are buying stock of the company, they must be an accredited investor. There is no such thing as a securities offering exemption for friends and family.
___ ii. either finance from friends and family as a loan with flexible terms; OR if the lender is both accredited and will put serious cash in the company structure the deal as a convertible note (see that section below)

5. Crowdfunding

Other types of financing is available such as crowdfunding. There are two types of crowdfunding. One is crowdfunding by sites like Kickstarter: where there is no exchange of equity for funding and instead gifts are given to funders. The other type of crowdfunding is where equity is exchanged for investments. This is a new phenomenon and there are many restrictions in place regarding this. I don't recommend this second type of crowdfunding method yet. There are better ways to finance the company.

6. Accelerators/Incubators

These are groups that will invest and purchase a certain % of the common stock of the company. They often provide office/workspace, access to influential members of the community and those experienced with having built companies in the past, advisors, etc. They also invest in the company using convertible notes.

Why this is good

i. a lot of accelerators and incubators can get a young company going

Why it sucks

i. some of these groups demand very aggressive financing terms that don't make much sense for the long haul

When you should use it

When the company is young and needs the funds and the network to help push it.

Make sure to do these things

___ i. watch aggressive terms in the financing documents. Be cautious of certain types of preemptive rights.

7. Convertible Debt

Convertible debt is a debt that converts into shares of stock. So if an investor loans the startup $100k, that money will not be paid back. Instead, at some point, it will convert into $100k worth of shares.

Convertible debt or convertible notes are securities. They are hybrid of debt and equity. This is the primary way that startups are funded in the early stage (see the end of this article for the sequence of what comes when.)

Sometimes convertible debt is called bridge financing because it is financing that bridges a company for a time until it can get even more financing. It's often used as a form of seed financing (i.e. early stage financing)

Attributes

Timing: the debt will convert into shares when the startup raises more money--typically in a Series A financing. This is the trigger point when convertible debt will convert into equity. In a Series A financing, investors will buy shares at a negotiated price.

Conversion: The debt will convert into whatever number of shares the amount loaned would buy at a price determined in the Series A financing. With the benefit of a discount because it is earlier in time.

What if it doesn't convert? Recall that startups usually can't pay back creditors. There may be all sorts of consequences. This should be detailed in the convertible debt documents. Some consequences may be that the note gets extended, the investor gets an X percentage of the entire company, the investor drives the company into bankruptcy.

Amounts

$0 to $1M

Who invests using convertible debt

Angel investors: These angels are investors that are typically made up of wealthy individuals that invest in private projects in seed rounds.
Institutional investors: This includes venture capital funds, firms, private equity firms, and others. They vary greatly in size.

More information

There's a lot more information as to the advantages/disadvantages of convertible debt. See Phase 3B: Financing--Convertible Notes for much more information on convertible debt.

8. Convertible Equity

This is just like convertible debt except it does not have the repayment at maturity provision. Many investors will not go for this type of investment.

More information

There's a lot more information as to the advantages/disadvantages of convertible equity. See Phase 3B: Financing--Convertible Notes for much more information on convertible equity.

9. Equity Financing/Priced Rounds

In a priced equity round of financing, the value of the company is determined and negotiated. Depending on that price, ownership shares of the company are purchased by an investor. These shares of stock are held as an investment by the investor and the company uses the funds received for operations and in order to grow.

The type of ownership shares that the investors purchase is typically preferred stock. The preferred stock purchase comes with all sorts of rights such as a liquidation preference and protective provisions. Common stock (the type of stock that founders and employees) are often bare bones. Preferred stock has rights above common stock and is what investors receive in a priced round.

Attributes

Terminology

What is the difference between Series Seed financing, Series A, Series B, etc.?

They are all similar in their underlying structure. All of them are rounds of financing where an investor purchases ownership shares of the company.

The difference is the size and timing of the rounds. A company will do a Series Seed round, then when it needs more financing--a Series A, then when it needs more financing--a Series B. Then a Series C. These are just sequential names and really could be called whatever the company and investors want to call them.

As time goes on these deals become for larger amounts of money and correspondingly increase in complexity.

A Series Seed round will typically raise amounts between $500k to $1M. Series A will be $1M+

Amounts

Series Seed: 500k-1M
Series A: 1M+

Who

More information

There's a lot more information as to the advantages/disadvantages of these types of deals. See Phase 3C: Financing--Venture Capital for much more information.

Part C: Startup Financing Steps

This is the sequence of financing for a startup and key points during each stage.

Step 1. Self-funding/Friends & Family

Keys:

For deals with friends and family--structure the deal as loans with favorable terms for founders or if the funding is for substantial money, then structure as convertible notes.

If it's not structured as loans and is a convertible note make sure the family or friend is accredited.

Step 2: Find investors

Keys:

People wonder how to find investors. You have to interface at different events. Go to where the investors are. It's like dating. Have to put yourself out there. Meet people. It takes work to find a good fit. Entrepreneurs need to polish their product and work hard at making the company better in order to attract investors.

Step 3. Seed financing: Convertible Debt (for raising $0 to $1M)

Keys:

a. Make sure investors are accredited
b. Read and follow the convertible debt tips section

Step 4: Seed financing: Series Seed financing ($500k to $1M)

Keys:

a. Keep an eye on money and control
b. Make sure investors are accredited
c. Keep an eye on dilution

Step 5: Series A financing ($1M+)

Keys:

a. Key an eye out on money and control
b. Understand that neither the entrepreneurs nor the investors are the enemies. Do business with people you can work with
c. Watch out for the liquidation preference

Step 6: Series B, C financing

Keys:

a. Structure is not unlike in a Series A financing
b. These investors at a minimum will demand the rights that previous investors received
c. Keep your eye on investor management
d. Keep doing more rounds of funding and growing, until you hit Phase 4: End Game.

Takeaways of Startup Financing 101:

- Startups use equity financing to finance their companies. They sell stock of their company to investors to raise money.

- Dilution occurs when equity is given to others. Those who already had equity before the distribution now own less off a percent of the company than they did before.

- A startup company needs to use accredited investors when doing an equity financing.

- A company should: 1. bootstrap or have friends and family finance the company; 2. then do a convertible note; 3. then do a Series Seed or Series A financing.