Equity financing refers to raising capital through sale of the company’s shares and/or other securities. In technology startups, the class of shares offered to investors will typically be created as part of the financing and will be specifically tailored to the investors’ needs. When issuing shares during any stage of funding, you must comply with applicable securities laws and should seek advice from legal counsel before proceeding.
Early-stage investors tend to use convertible debentures, common shares and warrants for seed or first rounds of investing. Convertible debentures are discussed below. Sophisticated later-stage private investors traditionally use other types of equity instruments.
A convertible debenture consists of a debt instrument (debenture) with:
For seed rounds, security rights of investors may include the assets of the founders.
Convertible debentures differ from traditional debt. The principal of the debt plus all accrued interest will be converted into the class of shares offered to new investors in the next round of financing at a price equal to (or at a discount of typically 10-30%) to the price of and on the same terms as the shares that are offered to the new investors.
This type of deal has become the frequent choice of angel and other groups who are providing seed funding to start-ups that expect to seek additional funding within a year of the initial investment round.
A convertible debenture is a non-valued investment. The benefit for founders/management is that deferring the value of the business may enable founders/management to increase the valuation beyond the amount of debenture financing. This can reduce the dilution to your ownership.
Investors prefer to use a debenture in seed rounds when they believe it is too early to determine a valuation. Also, existing investors may use the debenture between financing rounds to fund operations until your business’ next round of funding is complete without setting an interim valuation on the business.
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Houston, T., Johnson, A., & Smith, E. (2006, September 15). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Retrieved April 9, 2009, from Fraser Milner Casgrain website at http://www.techstartupcenter.com/