Take 5: Considerations For Raising Capital

As we kick off 2024, you might have big plans for growing your business. Part of that plan may include raising capital for the first time. This can be a daunting proposition. Asking for money is never easy, especially if you have not done it before. As you consider your initial capital raise, below are several factors to consider as you devise your strategy.

1.                   Debt Equity, or a Combination?

The first decision a founder faces when raising capital is determining the financial structure of the investment. There are three primary options: debt, equity, or a combination of both.

• Debt Financing: This involves borrowing money that must be repaid with interest. While it offers the advantage of maintaining ownership and control, the burden of regular repayments can strain cash flow, especially for early-stage businesses.

• Equity Financing: In this model, investors exchange capital for ownership interests in the company. While it alleviates the immediate financial strain, it can mean diluting ownership, giving up some control, and sharing profits with investors.

• Combination Financing: Some businesses opt for a hybrid approach, combining elements of both debt and equity. This can provide a balance between immediate financial injection and maintaining some control.

2.                   Type of Investment

Once the decision on debt, equity, or a combination is made, you need to decide on the specific type of investment instrument. Each option comes with its own set of advantages and considerations. Below are common types of investment instruments.

• Promissory Note: A promissory note is a written promise to repay a specific amount over a defined period with a specified interest rate. Founders should carefully consider the terms and obligations associated with promissory notes especially the rights of a lender in case of default.

• Convertible Note: A popular choice for early-stage startups, convertible notes start as debt but can convert into equity at a later date, usually during a subsequent funding round. This provides flexibility and avoids immediate valuation discussions.

• SAFE (Simple Agreement for Future Equity): Similar to convertible notes, SAFEs are designed to simplify early-stage fundraising as they use a widely accepted instrument whose terms are consistent and rarely negotiated. They defer valuation discussions, offering investors the promise of future equity when a triggering event occurs.

• Series Seed: As a more traditional equity financing option this option is more common in later-stage funding rounds and normally results in startups issuing a new class of preferred stock to investors. This provides investors with immediate equity ownership and often also results in a founder having less control over the business.

3.                   Who Are Your Investors?

Often where you are in your business lifecycle will determine who or what you seek capital from.

• Friends and Family: Often the first source of funding for founders, friends and family investors provide support based on personal relationships. However, mixing personal and business can be challenging, and founders must communicate clearly about expectations and risks and make sure the investment instrument used clearly states each parties’ obligations and rights.

• Angel Investors: These individuals, often successful founders or industry experts, provide capital in exchange for equity. Angel investors bring not only funds but also valuable mentorship and networking opportunities.

• Institutional Investors: These are professional organizations, such as venture capital firms, that manage pooled funds from multiple investors. While they offer significant capital, they often seek a higher level of control and involvement in the company.

• Venture Capital (VC): VCs are specialized funds that invest in high-potential startups. They bring substantial financial resources and industry expertise but usually require a significant equity stake and may influence key decisions.

4.                   Repayment Terms

For businesses opting for debt financing, understanding and negotiating repayment terms is crucial. Repayment terms include the interest rate, the duration of the loan, and any covenants or conditions set by the lender.

•   Interest Rate: The cost of borrowing money. Founders should negotiate competitive rates that align with the business's financial projections.

• Loan Duration: The period over which the loan must be repaid. Longer durations may result in lower monthly payments but can increase the total cost of borrowing.

• Covenants: Conditions set by the lender to ensure the business maintains certain financial ratios or behaviors. Founders should carefully review and negotiate these to avoid unnecessary constraints.

5.                   Maintaining Control

Equity financing often requires founders to relinquish some control over their businesses. Understanding the implications of this decision is crucial for the long-term success and sustainability of the company.

• Voting Rights: As ownership shares are distributed among investors, voting rights become a key consideration. Founders must carefully negotiate voting rights to maintain decision-making influence.

• Seats on the Board: Investors may request seats on the company's board as a condition of their investment. While this can bring valuable expertise and guidance, founders should consider the impact on the decision-making process and strategic direction of the company.

This article is meant only as a brief introduction of certain factors to consider when raising capital. If you have specific questions about raising money, we’d love to connect!

LetsGo@cruxterra.com