What type of financing should entrepreneurs use? The answer, of course, is “it depends”. The right choice is contingent upon the characteristics of the business model, the business’ stage of growth, and the specific funding objectives of the business.
In addition, it is a far more complex decision than “debt or equity?”. The line between debt and equity is blurred by all the different financing terms that have been developed to meet the needs of entrepreneurs and investors alike. The variety can be intimidating, but learning to evaluate risk versus reward will help you understand the impact of any financing term.
In part one of this two-part series we discuss the characteristics and terms of financing in general. In part two we will discuss different business characteristics and which financing terms fit them. This is written for those without a finance background.
Note: In this article the term investor describes both equity-holders and debt-holders (including commercial banks).
Financing is Evaluated Through Risk and Reward
When comparing forms of financing, always think in terms of risk and reward. How is the investor rewarded if the business venture turns out well, versus what risk does the investor have if things go badly? What is the risk to the business and the entrepreneur if payments or projections are missed versus how is the entrepreneur compensated if things go well?
Reward does not come without risk. The more protected the investor/entrepreneur is on the downside, the less they should be rewarded on the upside (and vice-versa). For example, the interest rate on a traditional loan rewards the investor with the same amount, regardless of the company’s performance. In return for accepting lower rewards when the business does well, the investor has less risk as debt-holders are paid at a proscribed time every year and, if things go badly, they get paid before other shareholders. The entrepreneur on the other hand has greater risk from a loan’s downside because not paying back loans can lead to bankruptcy. However, the entrepreneur has greater rewards from the upside because debt is almost always cheaper than equity from a cost of capital perspective.
There is no limit to the variety of methods available to write risk and reward into a financing contract, but some of the most common ones are listed below. Spotify’s recent financing with $1 Billion worth of convertible debt is used as an example because it has many components that are not normally seen everyday. Convertible debt means it’s a loan now, but the outstanding balance on the loan can be converted to shares in the future. In Spotify’s case, this conversion will happen when they do an initial public offering (IPO).
Controlling Risk: How are Investors Protected if Things Go Bad?
Collateral – Security on the Financing
If a business borrows money to finance the purchase of a machine, the machine itself is almost always pledged to the investor in the event the loan cannot be repaid. This is called a secured loan as there are specific assets pledged against it. The security lowers the risk on the loan for the financer. In the case of a startup with limited tangible assets or revenues, an investor will often require a startup founder to pledge their own personal assets in order to secure a small business loan.
Collateral is not restricted to physical assets. Creditors can also have liens against accounts receivable or the company’s cash account, for example.
If there is no specific collateral, the loan is called an unsecured loan. Spotify’s $1B convertible debt is probably unsecured, as Spotify doesn’t have $1B worth of assets to use as collateral. Unsecured loans still have a claim on a company’s overall assets in case of a bankruptcy, but secured assets are removed from the pool of assets that an unsecured creditor has access to. Thus, unsecured creditors will realize a smaller portion of their claims than secured creditors.
Priority – Who Gets Paid First?
The prioritization of creditors can get complicated, especially in bankruptcy proceedings. In general, the government gets unpaid taxes first, then debt-holders are compensated, and finally, equity holders get the left-overs. Within each category there can be additional priority. For example, preferred shares receive both dividends and the proceeds from the liquidation of the company prior to common shares. Preferred shares are often stripped of their voting rights in exchange for this higher priority.
Prioritization is not only important in a bankruptcy. Say Spotify continues to struggle amid a stagnant tech market. The directors decide that an IPO does not make sense as an exit strategy any more, and Microsoft decides enters the music streaming industry by purchasing Spotify privately. Priority plays a big role in how the money paid by Microsoft is divvied up among Spotify’s shareholders. There are terms on preferred shares that can set minimums and (rarely) maximums to how much preferred shareholders are paid in these situations. Remember, founders are usually common shareholders, meaning they only get paid whatever is left over after everyone else. A founder’s payout can be eaten up by preferred shareholders pretty easily if a minimum return is specified in the contract. ‘Middle’ scenarios such as this one are often ignored by entrepreneurs who usually think their venture can only be wildly successful, or a total flop.
Equity Dilution Protection
If you own 10% of a company and the business doubles the number of shares by raising additional equity funding, you now own 5% of a company. Dilution protection stops this from happening, effectively reducing risk to the investor. This protection is very common in private equity deals, although the terms by which it is implemented can vary. Dilution protection forces entrepreneurs to think about how they are going to use shares in their company early on. For example, a portion of ownership needs to be set aside early on for stock options given to future employees.
Controlling Reward: How are Investors Rewarded Differently?
Participating in the Profits of the Business and the Proceeds from the Sale of the Business
We often forget this, but dividends are the main reason stocks have any value. At some point in the future, a business has to either start issuing dividends to investors, or work with shareholders to sell the organization. The creditors who gave Spotify the $1 billion loan do not currently have any right to Spotify’s profits, but they will upon conversion of the loan to shares when the IPO happens.
Interest
Interest is the core characteristic of debt. In the case of Spotify’s financing, they are paying 5% interest for the first 6 months. The interest rate then increases by 1% every six months until it reaches 10%, at which point it is capped. This is a very low interest rate for a firm that is still showing substantial losses, but the investors plan on making their money from converting the debt to shares. Major corporate debt is often structured differently from a home mortgage, for example, in that the principal is returned in one payment at the end of a fixed term. Payments are usually made bi-annually on the interest only.
Shareholders Voting Rights
Most, but not all, shares have voting rights. For example, Google’s unique share structure has some shares with 10 votes each, others with 1 vote, and some with no votes at all. This allows founders to raise equity financing without giving up the ability to influence who sits on their board of directors. From the other perspective, voting rights allow equity holders to influence the direction of the company to protect their investment if they don’t like what the founders are doing.
Debt Convertibility to Equity
In the case of Spotify, 100% of the debt they issued is convertible to equity when they get to IPO and they convert it at 20% less than the issuing price, with that discount increasing every 6 months if they don’t go to IPO within a year. These are exceptional terms as usually only a portion of a loan is convertible to equity. This is done to sweeten the rewards for the creditor if things go well, while still providing priority over equity on the downside.
In this particular case though, Spotify is avoiding putting a value on its company amid the current slump in the tech sector. Spotify is buying itself time to put off its IPO for a year. Debt can be very useful for extending the runway between investment rounds.
When Can Investors Sell Their Stock?
In the short term, stock prices can have as much to do with supply and demand as they do with the long term value of the company. That is why Spotify’s recent investors made sure they get to sell their newly converted stock 90 days post-IPO, well before the 180 days when all of Spotify’s employees can sell theirs.
Always Think About Risk and Reward
The list of financing terms we have provided is not comprehensive. For a more in-depth discussion of debt and equity terms, read George Deeb’s Comparing Equity, Debt and Convertibles for Startup Financings article.
The moral of this story is that any financing terms can be understood by thinking about the risk and reward for both parties. By adding in realistic likelihoods for the various possibilities, determining if an offer is truly fair should be that much easier. Keep in mind though that fair for one party does not always mean fair for the other party. Trying to find mutually agreeable terms is the biggest challenge.
See you for part 2 where we focus on the entrepreneur’s point of view and discuss what terms might make the most sense for your business.