Capital Basics: Five Categories of Financing

The Jason Wiener, p.c. blog has a significant and growing section on raising capital for a business. This post will go back to the basics and briefly describe the five categories of financing: debt, equity, convertible debt, grants, and rewards-based fundraising. Most types of fundraising fall within one or more of these areas.

Debt: Debt financing is when an investor exchanges liquid cash for a promissory note (the legal term for a promise to pay). The promissory note typically includes principal investment with an interest rate, which may be variable or fixed. The promissory note also includes a fixed maturity date, which is the date by which the principal and interest must be repaid. Common examples are any type of loan and extensions of credit.   

Equity: Equity financing is simply when an investor takes an ownership interest in a company in exchange for a liquid investment. This can be a major investment that would result in, for example, half ownership of the company or a small investment, such as buying a single share of common stock. Some examples include revenue-based financing, venture capital, and initial public offerings (IPOs).

**A note on debt and equity. Many investors use either debt or equity or some combination of the two. For example, angel investors, which are wealthy individuals or groups investing on behalf of themselves, may require either debt or equity in exchange for funds. Often angel investors invest in a business at a very early stage. Small Business Investment Company’s (SBICs) are private investment firms that are, at least in part, funded by the SBA. Similar to angel investors, SBICs may accept debt and/or equity in exchange for investments.

Convertible Debt: A convertible debt is an instrument often used for early-stage startups. Essentially, the financing starts out as a debt and may convert to an equity interest in the future. A business that receives this type of financing will be liable for the financing, as they would a debt, however after an equity-triggering event, the investors interest will become an equity interest. Examples of events that might trigger a conversion from a debt to an equity interest include:

  • Qualified financing: this is when the value of the company reaches a particular amount relative to the amount raised in convertible financing and that valuation triggers an automatic conversion. For example, if the company raises $100,000 in convertible financing and the parties agree that the qualified financing will trigger at $1,000,000; once the company’s value is determined to be at least $1,000,000 in a future financing round the investors’ debt automatically converts to an equity interest.
  • Optional conversion: the investor can elect to convert their debt to common stock if there has been no qualified financing and the convertible promissory note reaches its maturity date.

The reason many early-stage creditors favor this type of financing is that the company often does not have a value, or has a very low value, at the time the funds are requested. However, once the company is more established, for example after a seed round of financing, the company can determine a more meaningful valuation. 

A similar instrument is a “SAFE,” or simple agreement for future equity. SAFEs are template transactional documents which allow for a future equity interest. Also a “debt-equity swap” is an older version of this; in which an investor, who never held a convertible debt, accepts an ownership interest to settle the debt.

Grant: A grant is when an investor, or government agency, provides capital to a company without the expectation of repayment or taking an equity interest in the company. Often investors grant funds to companies to execute a particular purpose, but that is not required. 

Forgivable loans are loans that convert to grants, provided that a recipient meets the criteria to make the loan forgivable. Recoverable grants are the inverse. Recoverable grants, which may also be called “soft loans,” provide entities with grant funds which must be repaid, sometimes with interest, if the business makes a profit. Investors will often make these available to mission driven social enterprises. 

Rewards-Based Fundraising: Rewards-based fundraising is when an investor provides funds to a company and expects goods or services in return. The funds provided are often in excess of the value of the goods or services exchanged. For example, investors may receive a certain item, a credit to the business, or some service.

Example in Focus: Crowdfunding

Crowdfunding runs the spectrum of many classes of funding. Some versions of crowdfunding include loans and, therefore, debt for the business. For some social enterprises, funding may come from particular investors who are willing to make loans at no or negative interest.

Crowdfunding based on an equity structure includes any sort of sale of stock. When a business makes its initial public offering, either through some existing trading forum or independently, they are fundraising in exchange for an ownership interest in the business.

Donation-based crowdfunding is another version of grant financing. In this model, the many funders do not expect any return for their investment in a business. GoFundMe campaigns are often examples of this type of fundraising.

Finally, rewards-based fundraising is a growing trend in crowdfunding. For example, Kickstarter and Indigogo campaigns often exchange funds for some reward item.

Example in Focus: Paycheck Protection Program (PPP)

The Paycheck Protection Program is a loan program to businesses facing hardship due to COVID-19. Businesses who receive money under PPP have two possible resolutions. Either the money will have to be repaid, in which case the funding is a traditional debt; or the business meets all of the requirements for loan forgiveness, in which case the debt converts to a grant.

We invite you to watch this more in-depth description of business financing on our blog.

 

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