We’ve all heard the stories about entrepreneurs who had a great idea to meet the demands of a fast-growing market, but ended up owning only a tiny sliver of a wildly profitable company. They’d given so much away to the folks who provided the money to get the firm off the ground that these entrepreneurs reaped little from their hard work.
There’s another common story, however, that we hear less often: Entrepreneurs who had a great idea, refused to give up any of their company in exchange for the capital they needed to grow and watched in frustration as the market raced down the freeway while their company remained stalled on the side of the road.
For the owner of a startup that has big potential for growth, the need to balance a company’s need for capital with the owner’s desire to give away a little as possible brings many sleepless nights.
Right now — today, in fact — is the best time for an entrepreneur to begin nailing down the funds for the company’s growth. The startup may be well-funded today, or it may not need much cash at this phase of its life. But it’s a rare company indeed that won’t need some outside cash at some point in its early days.
If you go searching for cash when you need it desperately, you can count on trouble.
Cash-flow problems will cripple the operations of a business, and they equally cripple the ability of a business to get funding on attractive terms. Funding partners are less willing to make investments in troubled companies, and they will unfailingly demand a higher price for the additional risks that they’re taking. That translates into a larger ownership percentage or tougher terms than they could demand if you had sufficient cash.
Simply put, you could lose control of your company if you wait too long to get additional financing in place.
Running your startup on a shoestring is a good idea, and there’s no reason to burn through cash unnecessarily. But begin making your plans for fresh capital before you need them.
A good first step: Develop a relationship with a trusted business advisor. Work closely with your advisor to accurately forecast your cash flow and monitor the capital you have on hand to finance the company’s growth.
You need to balance another asset as well: Time. Your company is racing against its competitors to get to market, and the delay of even a week or two can cost millions of dollars — or perhaps may cost the very life of a startup that loses the race.
If self-funding your company results in slow growth while competitors fueled by venture capital are racing to the finish line, giving up a piece of equity or taking on some debt might be critically necessary.
Convertible debt is one of the funding options that sometimes makes sense for startups, particularly those with large-scale growth potential.
Here’s why: Investors who provide capital in the form of convertible debt have the option to convert their loans into shares of the startup later on. Often, the conversion of debt into equity occurs when the first institutional investor puts money into the company. That triggers a valuation.
In the meantime, the company has matured. Instead of giving away a big portion of the company when its valuation is low, the entrepreneur can wait until valuation is higher before valuing the stock. If an investor buys $50,000 in stock in a freshly minted startup valued at $500,000, the investor can command a 10 percent ownership. But if the company’s valuation grows to $5 million before the debt is converted, the $50,000 investment becomes a one percent stake in the company.
Convertible debt is a particularly good tool for entrepreneurs who are raising money from family and friends. Because it’s debt, the transaction provides some protection to the folks providing the money. At the same time, the convertibility allows them to share in the upside potential.
But convertible debt isn’t for everyone. For companies still in their earliest startup stages, convertible debt is often available from angel investors only for small rounds of financing or maybe as a bridge between larger funding rounds. And investors usually want to see evidence that company can scale quickly to meet a high-growth market — the sorts of conditions that make convertibility into equity highly attractive later on.
Make sure, too, that you understand the terms of any convertible debt your company issues. The debt will carry a defined interest rate, which may be paid in cash or may be added onto the principal. The debt often converts into equity at some discounted price from the valuation set during a round of equity financing. The agreement will include a repayment term — usually six months to 18 months. Sometimes, the debt can be repaid early, although a penalty of as much as 50 percent of the principal amount isn’t uncommon.
All of these variables mean that you’ll want to work closely with advisors as you raise capital through convertible debt.
In the final analysis, raising money wisely is the most important factor in your company’s success.
John Solari is the owner of J.A. Solari & Partners, a Reno firm specializing in accounting, tax preparation, business consulting and strategic planning.
