Most startup founders do not have enough capital to launch their companies and need to raise money at some point. The first milestone in a new startup’s financing is called ‘Seed Capital’ which refers to the initial investment raised by the founders from their friends and family, or commonly referred to as FFF (Friends, Family and Founders), who mostly use their personal assets. It is used to cover initial expenses until the company is able to attract the attention of venture capitalists. FFF investing is not a short-term play and mostly investors do not get a return on their investment immediately. The return only happens when there is an exit via acquisition or an IPO.
Raising Angel Capital
Individual investors who provide financial funding to startups are called ‘Angel Investors.’ Angel investors may invest individually or as part of an angel group, which are usually local organizations made up of Accredited Investors*. Some well-known Silicon Valley angel groups are Band of Angels, Sandhill Angels, TIE angels and others.
Per SEC rules “accredited investors” need to meet one of the following criteria:
1. Have an annual income of $200,000 or more per year for past two years (if married, $300,000 jointly with spouse) with a reasonable expectation of the same income level in the current year or
2. Have $1,000,000 in assets excluding the value of their primary residence.
*The above definition of accredited investors is being currently reviewed by the SEC in terms of current financial thresholds of income and net worth.
Convertible Debt Financing
Since investment in a startup is risky and most people are reluctant to contribute funds, startup entrepreneurs can use different ways to make funding from FFF look less risky. Among the most common methods of funding used by startups when raising seed capital is “Convertible Debt Financing.” “Convertible Debt” is a loan, which is automatically converted to equity at maturity or upon the closing of a round of financing. Convertible debt must have interest rates at the Applicable Federal Rates (AFR) published by the IRS monthly at AFR Rates. Bridge notes/loans are an example of convertible debt. Convertible debt provides startups with a relatively easy way to procure financing. Various terms such as price cap, discount, conversion to equity, etc., can be incorporated in the agreement at the time of financing.
Pros and Cons of Convertible Debt
Pros of convertible debt:
• Startups have to pay simple interest and not compound interest.
Cons of convertible debt:
• On maturity both accrued interest and principal are due.If maturity date is reached and the startup is unable to secure a round of financing, note holders can force the startup into bankruptcy.
• With many investors and many notes with different maturity dates in a seed or a financing round, calculating interest payments can be time consuming and complicated.
Example: An angel investor contributes $300,000 convertible note to a startup. The terms of the note are 10% discount and an automatic conversion after a financing of $1,000,000. (Note: The discount is appropriate as it is a reward for early investors to invest in a startup, which has zero or little funding). Let us assume there was a financing of $1.5m and the share price is $1 for the current round of funding.
While others get share(s) for $1, the angel investor gets it for $.90 ($1 * 90%) since there is a 10% discount. Shares received by angel investor for $300,000 investment = $300,000/$0.90 = 333,333 shares.
Return on investment = ($333,333 – $300,000)/$300,000 = 11%.
In addition to convertible debt, other methods can be used to pay back FFF such as:
1) Fixed repayment schedules tied to company’s future cash flow(s)
2) Giving equity in the company
3) Giving non-voting stock
NOTE: Angel investors are typically allocated common stock, the same class of stock as owned by founders, as opposed to preferred stocks, which are offered to VCs.
Arushi Bhandari, CPA, MBA blogs regularly at www.startuptaxaccounting.com. She recently published an ebook with insights about the impact of JOBS Act & Dodd Frank Act on startup funding, terms like angel, accredited investors, venture capitalists, stock options, Restricted Stock, RSUs. It gives in depth examples & templates explaining documents like Term Sheet, Cap Table, Convertible Securities plus the importance of 83(b) filing.