An Introduction To Raising Money For Your Startup
Small businesses may piece together funding from several different sources—such as bank loans, friends and family, or equity investors. Read this article to learn more about financing options available for startups and small businesses, as well as a few tips on what you should know about securities laws. Bonus: learn about new and easier to use financial instruments to raise money.
Debt vs. Equity
Companies primarily raise capital externally by either debt or equity. A company uses debt when a bank or investor loans it money in return for the company’s promise to pay it back, usually with interest and in accordance with agreed upon terms. On the other hand, a company uses equity when an investor gives the company money in exchange for ownership.
The benefit to using debt rather than equity is that a founder retains ownership of the company. The downside, however, is that the company must repay interest on the loan, in addition to the principal loan amount. Additionally, debt can have negative consequences on the company’s profit ratio and overall valuation.
The benefit to using equity rather than debt is that a company does not need to repay the money. The downside, however, is that the company gives up ownership and this, in some circumstances, means giving up some control over how the company is managed and operated.
Friends and Family
Friends and family often provide a great source of financial capital because they are closest to you and more likely than anyone to believe in your business idea (and in your ability to make the idea a reality). Founders may raise money through friends and family through gifts, loans, or equity.
A friend or family member may give you up to $14,000 each year as a tax-free gift, meaning you have no obligation to repay it.
Friends and family may lend you money at below-market interest rates because they are more interested in supporting your business efforts than making money off of it. However, the downside is that you are risking your personal relationships if your business fails. To better mitigate this risk, you may want to structure this type of funding as a high interest loan for one year.
A company may also sell business shares to friends and family and make them equity investors. In this scenario, the lender friend or family member becomes a co-owner in the business. This is the riskiest option for family and friends because there is no guarantee that they will get their money back. Securities laws also require companies to comply with various regulations when entering into these “investment contracts,” which can accumulate high fees in professional services to draft and register the investments.
Business owners who seek funds from individual investors must provide specific factual information to potential investors so that they can evaluate the investment and determine whether it is right for them. The US Securities Act of 1933 and the Securities Exchange Act of 1934 regulate companies’ legal obligations to its investors.
In short, a business that offers a “security” to a purchaser must register it through the Securities Exchange Commission unless it qualifies for an exemption. A “security” covers a broad range of interests such as any note, stock, bond or investment contract. Most often small businesses seek to qualify for an exemption since securities registration often comes with a lot of paperwork and high legal costs. The right exemption for a company depends on how the company plans on soliciting investment, the number of investors, and the investors “financial sophistication.”
Startups and investors structure investments by using various financial instruments such as stock, convertible notes and, more recently, SAFEs and KISSes (these are the bonus!).
A SAFE, which stands for a simple agreement for future equity, is a standardized one-document security that offers investors a contractual right to buy a company’s stock in the future upon the satisfaction of certain conditions.
Startup companies prefer to use SAFEs because these documents are relatively easy to use and have no maturity date and do not accrue interest. Some investors, however, may be weary of using SAFEs since they are relatively new instruments with uncertain tax consequences and a lack of certain investor protections.
A KISS, which stands for the keep it simple security, may provide a middle ground for those investors unwilling to use a SAFE. The KISS may offer qualifying investors more protections than a SAFE, such as information rights and the right to participate in the company’s future financing. The KISS comes in both debt and equity form. The debt KISS lacks the attractive features of a SAFE because it accrues interest and matures on a given date. The equity KISS, however, does not accrue interest and poses the maturity date as the date following which investors may elect to convert into priced equity at predefined terms.
Overall, startups seeking initial capital or small businesses seeking money to grow have several different options available to them. A company may choose a debt or equity structure depending on the founders’ willingness to take on debt or alternatively give up ownership rights. Either way businesses must be careful to comply with securities regulations. Founders may reduce startup costs by using a SAFE or a KISS instrument. Feel free to contact us on for more advice on what options will work best for your business.
Disclaimer: The information in this article is presented for informational purposes only, and should not be taken as legal advice. Before acting on any information presented in this article, you should consult an attorney regarding the facts of your specific situation.
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