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  • Writer's pictureCharles Edge

Common Financial Instruments Used To Fund Startups

We occasionally mention various financial terms in articles. Some are types of securities held by investors in exchange for providing funds for a startup. Make no mistake, investing is financing - just like a bank. The nuance in the words we use often comes from the industries we operate in, with the type of risk associated, and from the parties involved. That nuance then often translates into specific sections found in those contracts that wouldn't be found in a typical bank loan, 401k, or line of credit.

While traditional financial institutions might invest in funds that invest in startups, they don't often do so directly in the software industry. Banks lend money in exchange for a security when that money isn’t repaid. So a bank might hold the deed for land or title for a car until a loan is repaid. Companies come and go all the time. The smaller the company, the bigger the risk. And without a founder much of the intellectual property of a software startup isn't as valuable as other securities.

New and innovative ideas (and so companies) fuel growth for societies, as they have going back to the Greeks, Egyptians, and beyond. So they need to be funded. Therefore, investors provide that funding and so share the risk and then the rewards.

The types of investments dictate the types of returns. Banks have a standard risk profile they like to work with and a regulated reward system. When a bank provides a mortgage for a home, they take the loan-to-value ratio (so the value of the security they hold), the credit score of the lender, income levels, and other factors that help them derive how risky an investment we are based on whether or not we will pay the mortgage off. The mortgage provider can charge more, the riskier the investment, but regulators in various countries typically limit the scale of the increase.

Investors buy shares in companies, or issue financial instruments that seem more like a traditional loan with additional rights that often involve converting that security to equity. This means that investors are often far closer to founders in the earlier stages, where the founder themselves (often more than the big idea) is the riskiest aspect of the investment. The investor then makes a judgement call around what the investment is worth. A simple example might be that 5% of a given company is worth $100,000. Then, it's just a matter of choosing the right tool to provide that financing.

In 1957, one of the first venture capital firms, American Research and Development Corporation (AR&D) invested $70,000 in a company called Digital Equipment Corporation (DEC for short). At the time it seemed like a pretty risky investment as Ken Olson was just leaving MIT to build computers - which at the time meant going up against the behemoth IBM. No one would bet against IBM. That investment netted over 5,000 times the capital provided in 1968 when DEC, then valued at $355 million did their initial public offering. Turns out Olson helped usher us out of vacuum tubes and into the era of transistorized computing, becoming the number two computer company of the age, behind IBM.

The term sheet Georges Doriot from AR&D gave DEC was a simple one page offer that his firm would buy 70% of the company. Evolutions in the technology industry, investment strategies, tax codes, and regulatory requirements force us to have more complicated agreements and provide more options these days. Most founders would get mad and run out the door or laugh maniacally if offered less than $100,000 for controlling equity in their company. But inflation, so adjust that $70k to around 9 times that pretend we're talking about investing in teleportation and it might make a little more sense. Because that's pretty close to what these people were thinking about. And keep in mind that AR&D returned an annualized 15% ROI to investors, not over 100% as they got with the DEC deal - meaning they picked a lot of companies that didn't make it as well.

Again, our thinking has evolved since those early days in venture capital (and alumni of AR&D went on to found firms like Greylock who fund innovative startups to this day). But the fundamentals are the same. Investors take a risk on funding an organization formed to support an innovation. We use a variety of financial instruments in that pursuit.

Deals can still be made to support any type of situation, but many are now bucketed into specific categories in order to put the deal machine at firms on a bit of an assembly line and reduce the legal costs by repeating the use of some of these ways to fund. Some the community keeps going back to include the following:

  • A Loan: We put this first because it’s the most traditional financial instrument: one party provides a loan, like a bank does (in fact it might be a line of credit at a bank). Usually backed by a security (e.g. a mortgage or ownership of the company). This is not a common way to fund a company as the risk is high for the lender.

  • Common Stock: The simplest startup financing is to sell shares in the corporation. Doing so dilutes equity but all shareholders understand exactly what is in the term sheet and the company could be formed as an LLC and operations simplified as opposed to taking on additional tax and financial complexities introduced with different types of shares and financial instruments.

  • Convertible Note: A short-term debt that converts into equity in a future financing round. Dilutes equity at conversion, often with interest. Conversion can come with preferred or common stock.

  • Simple Agreements for Future Equity (SAFE): Shorter than the traditional convertible note with less terms (and so cheaper to do all the legal haggling). Doesn’t usually come with interest at conversion.

  • Equity Crowdfunding: Equity funding by groups of investors through crowdfunding sites.

  • Debt Financing: Investment made using a financial instrument that requires repayment of the principal plus interest.

  • Corporate Round: Investment round led by another company, often in an adjacent market.

  • Initial Coin Offering (ICO): Similar to an IPO but using a crypto-currency instead of publicly traded shares.

  • Private Equity Round: Late stage investments, often (but not always) made on underperforming organizations for a larger percentage of equity if not for all equity.

  • Post-IPO Debt: Debt taken on by a publicly trading company.

There are historical examples of every possible outcome we can think of. Control Data Corporation (CDC) allowed Dr. Michael Allen to take his ideas in exchange for a loan that, if repaid early, would actually be repaid at a fraction of the cost. This is because by then, Control Data had grown to the point they could not weaponize all of the innovations coming out of the late, great corporation and the acceleration of getting some money in exchange for the intellectual property he took with him was better than getting nothing. That company would later be merged into Macromedia and then Adobe. The "investor" had the impact desired and received compensation.

There are thousands of little intricate details around how to finance a company. As we’ve explored the more common (or more visible even if less common) there are plenty of financial instruments available for whatever outcome is desired. But there are so many other details to make sure to get right in a term sheet, like regulating the secondary sales of stock or the dilution in future rounds. Most founders aren’t savvy financiers - and those who are likely need a second opinion on matters, so make sure to have good legal and financial representation before signing those term sheets.

Make sure to be intentional about how much equity given up and what triggers what; that could be the difference between maintaining control of a company and being on the sideline during really good or really bad times. Chances are that different people might be able to run our companies better at different stages of their growth, but when possible, founding teams should retain the agency to be able to make that decision themselves.

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