Published in the New Hampshire High Tech Council
Newsletter
When a company is in its earliest stages of growth, it will likely
not have much of an opportunity to pursue traditional loan
financing arrangements with commercial banks or credit unions. The
reason, of course, is that the company will not yet have a fully
developed product or service and revenue stream, and it is
therefore not always capable of paying the debt service on a line
of credit or term loan. Early stage startups should not be
discouraged from what may initially seem like the daunting
challenge of raising enough capital to develop, and later scale,
their business. As discussed below, there may still be
opportunities for the company to raise capital.
In its earliest stages of development, a startup will typically
seek to raise capital by either: (1) selling preferred stock in the
company, or (2) issuing convertible notes to angel investors, both
of which preserve the founders' common stock equity interests
in the company. Preferred stock is a class of stock in the company
that gives the investor equity in the company along with additional
rights, often liquidation, distribution, and voting privileges. A
convertible note is a debt instrument that gives the investor the
right to convert the note into preferred stock at a future date,
generally when the company closes a later round of financing or is
purchased by, or merged into, another company.
For an early stage startup that has not yet taken its product or
service to market, it is often wise to consider using a convertible
note financing to raise capital. The reason behind this financing
decision is that a convertible note defers most key terms related
to the rights granted to the investors, while a preferred stock
offering requires immediate agreement to terms among the parties.
The first advantage to the deferral feature inherent to the
convertible note is that it provides the opportunity to use the
capital raised from the note offering to achieve certain milestones
– such as developing a prototype or closing a sale with an
important client – prior to setting a valuation for the
company.
This can ultimately serve to increase what would have otherwise
been a low valuation for the company and preserve the founders'
equity from being diluted to the extent it would have had the
company sold preferred stock instead.
This feature similarly preserves the founders' voting and
distribution rights for the interim period until a triggering event
leads to the conversion of the investor's investment into
equity.
On a practical level, a result of the deferral feature in the
convertible note is that it is generally a simpler document to both
prepare and negotiate than its preferred stock offering
counterpart. A note financing therefore tends to cost less and can
close in as quickly as a few days. A preferred stock offering, on
the other hand, typically requires significantly more negotiation
and the development of more comprehensive offering materials.
Regardless of the financing arrangement, it is important for the
startup to consult with an attorney to ensure that it complies with
all corporate and securities laws associated with the capital
raising process.
Matt Whitehead is a corporate attorney at McLane, Graf,
Raulerson & Middleton.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.