Businesses Need Capital. Businesses often need capital to grow. The type of capital that a business needs (and also what it can attract) is a function of its stage of maturity. In the early start-up phase, working capital usually funds basic operating expenses while building and commercializing a product or service and beginning to attract early customers. Funding often comes from friends and family and angel investors. As businesses grow and expand, additional capital is needed to expand marketing sales and distribution and begin scaling operations. With exceptions, rarely can a new business self-fund its growth from net cash flow and even those that can are making a tradeoff by slowing down potential growth due to working capital constraints. As businesses mature and head towards projected profitability or reach initial profitability, additional capital becomes available from various investment sources such as venture capital, venture debt, and strategic capital sources. With positive net cash flow and earnings, additional tranches (or rounds) of capital can be sourced for a variety of needs, including cash flow management (lines of credit), new product development, market vertical expansion, manufacturing and facilities expansion, acquisitions, and other uses. As different types of capital are layered into a business, a capital stack is created like a layered cake with various credit facilities and investments having different relative rights and priorities. Within this mix, original founders and shareholders need to be aware of the economic effects a capital stack has on their ownership holdings both in the short and longer term. The fundamental goal of both the owner and equity investor is to grow the value of the business, and for lenders to ensure they are repaid with interest.

Understanding Debt and Equity Financing.   Though debt and equity are often used to finance business growth, they are distinct.  Debt financing is a loan, and your lender is a creditor. Equity financing is the sale of an ownership stake in your company.  As between the two, a lender (as a general rule) has a higher priority right to payment before any equity owners (i.e., shareholders, partners, or members depending on what type of entity you have). 

Financing structures can become very complex, especially when institutional investors are involved, such as hedge funds, venture capital groups (VC), venture debt groups, merchant banks, and factor-based lending.  

Debt Investments.  Often when it comes to debt-based investments, an equity component will be present.  This may take the form of a warrant option to acquire stock or an ownership interest at a later point in time, or could be a conversion right where a loan can be converted into stock or an ownership interest.  Other variants on this theme may include something called a “kicker” which is an additional payment in addition to repaying principal and interest based on a percentage value of your company at the time of another capital raise or sale of your business.  Debt may also be layered, meaning you can have something like a traditional secured bank loan and then have another business loan or debt facility that sits “behind” the bank.  This is called a subordinated loan or junior loan.  Typically, a subordinate lender (because they are second in line in payment priority) takes more credit default risk, and the cost of the loan is higher (this can be reflected in a higher interest rate, a kicker, an equity participation component, or other forms of compensation).

Equity Investments.  An equity investment involves the purchase of an ownership interest in a business.  For corporations, this is a purchase of shares of stock.  For partnerships and LLCs, it is a purchase of a percentage ownership which may be expressed as a percentage or in units that are representative percentage shares of ownership.

However, not all stock or ownership interests are necessarily equal.  There can be different classes of stock or ownership interests that have different rights.  A classic example is something called “Preferred Stock”.   Preferred stock (which can also have multiple classes or series with differing rights and priorities) usually has special rights that put it ahead of common stock or junior ownership rights.  These special rights can include “liquidation preferences”, “participation rights” and “voting rights”.   A preferred stock looks somewhat like debt because it requires the company (the “issuer”) to repay the principal investment amount along with accrued dividends at a prescribed rate and often by a time-certain (this is called a “mandatory redemption” right).  A liquidation preference means upon a sale or liquidation of a company the holders of preferred stock get paid back from the proceeds first before common stockholders or other “junior classes”.   A “participation right” means in addition to being repaid the redemption amount, the preferred holder is entitled to also participate in a percentage of the remaining proceeds that would be distributable to common stock or junior stockholders.

Investment Form, Pricing, and Rights Mix.   Understanding how to balance the cost of capital (pricing) along with other factors such as time horizon, form of investment, and investor rights is important in maximizing the outcome as an owner.  From an investor perspective, the objective is obtaining the highest return on investment with the least amount of risk.  For the business owner, the objective is to take in capital and grow the value of the business at a rate that exceeds the cost of capital.   

Venture capital plays a vital role in early-stage and mid-stage businesses because this type of investment assumes more risk in exchange for the prospect of an outsized return.  A great venue capital (VCs) return is in the range of 5x to 10x on investment and a decent return is 3x to 5x.  Even though VCs play in the higher-risk investment space, VCs still use various tools to “de-risk” their downside.  For example, it is not uncommon for the terms of an investment to be structured with a multiple on a liquidation preference from 1.5x to 2x their investment.  What this means in simplistic terms is if $10M is invested, the first $10M of proceeds from a sale of the business goes to the VC.  If the business can only command $2M in the market, then the founders and common holders would receive nothing!

Debt financing is often favored (though not always) over equity financing because it carries a lower cost of capital and is non-dilutive to ownership. Debt financing rates range based on risk, the level of security, and a positive earnings/cash flow profile that can support the debt service. “Junk rates” are often a function of a prime lending rate but can be as much as 16-18% per annum.  In the case of receivables financing, actual rates can reach 30% when considering turn rates.

Pricing in general can be broken into 2 basic components: (1) pre- and post-money enterprise valuation, and (2) the actual or implied financing rate.  In the case of preferred stock, there is a dividend rate that can accrue on the principal investment which becomes payable at the time of redemption.  In the case of debt, it is typically based on the interest rate and the dilutive value of any equity kicker.

Business owners are often concerned with “dilution”.  Dilution is a function of pre- and post-money valuations.  Often, the focus is mistakenly placed on the percentage dilution instead of post-money valuation (i.e., the price paid by the investor to purchase an interest) and the longer-term growth-driven value accretion opportunity that additional capital offers to the enterprise.   

The Role of Multiples and Public/Private Valuations.  A multiple is a quick method of determining enterprise value.  Multiples, as the name implies, are taken against financial benchmarks such as TTM (Trailing Twelve Month Sales), EBITDA, net earnings, and other metrics.  These multiples generally correlate with more sophisticated valuation methods such as discounted cash flow (DFC), book value, and comparative transaction-based methodologies and are usually business segment oriented based upon the particular behavioral economics of the space (i.e., a utility vs. an equipment manufacturer vs. a SaaS software company).   In actuality, though, ascertaining valuation multiples is fairly straightforward for public companies.  NYU Stern has a great resource to determine your industry’s multiple here:  https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html. 

Some of the factors that play into higher multiples are the type of revenue, compounded annualized growth rate (CAGR), and gross margins. Fast-growing companies that generate high-margin, annuitized revenue generate higher valuation multiples than counterparts that do transactional sales with low or no residual revenue stream generation.  SaaS-based companies for this reason enjoy comparatively high multiples.

However, private companies do not enjoy the same multiples as public companies and usually are discounted from 20% to 50% depending on the size of the private firm and other factors. This is where many larger funds like to do industry roll-ups because they can arbitrage the public vs. private valuation multiple either folding private firms into a public company or taking the consolidated entities public. 

Early-Stage Investment - What is a SAFE Agreement?  SAFE stands for “Simple Agreement for Future Equity” and is very popular among start-ups.  The SAFE concept was started and made popular by Y-Combinator, one of the most prolific and well-known start-up accelerators in the world, facilitating early-stage/ seed investments.   Touted for their simplicity and founder-friendly terms, a SAFE agreement generally has the following characteristics (though they can be and many times are often modified in negotiations):

·       Investors agree to make an investment in the business.

·       The business agrees to sell the investor stock at a discount when a triggering event occurs at a later date.

·       In between the investment date and the triggering event, the investment accrues a preferred dividend.

·       A triggering event is usually a future round of additional capital, sale, or merger, and at that stage, the investor may (depending on the transaction type) either cash out or take stock issued in the new round of equity sold.

·       If a triggering event doesn’t occur within a prescribed window, the business must repay the investment and accrued dividend amount.

·       If the company can’t pay back the investment plus accrued dividends, the founders are not personally liable to repay it.

·       If a liquidation occurs (the company goes out of business) the investor has first priority to any liquidation proceeds to get their investment back.

Despite their marketing allure and apparent simplicity, SAFE investments are not necessarily “safe” (from an investor perspective) nor simple (from a founder-owner perspective). In fact, the U.S. Securities Exchange Commission (https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_safes) has issued an investor bulletin addressing precisely these points.  Additionally, it is very common for various informational resources to wrongly state that SAFE investments are not subject to securities laws because it is merely a contract to buy company stock in the future if certain events occur.  This is patently false.  The Securities Act of 1933 and its regulations require registration absent an exemption from the registration requirement.  There are various exemptions from registration under the ‘33 Act, including under Regulation D, A, and CF.  These exemptions carry various limitations and requirements, and some limit the amount that can be raised.  

Overall, the suitability of a SAFE investment arrangement depends upon the superficially simple, yet precise details of the SAFE Agreement.  From a founder's perspective, the greatest risks are (a) failing to understand the dilutive effects of what is essentially a future conversion right, (b) failing to appreciate any time windows when a trigger event must occur, and (c) understanding if the business fails to perform, there is a real likelihood founders will be left with nothing on liquidation.