Published in the New Hampshire High Tech Council Newsletter
By: Matthew D. Whitehead
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. He can be reached in the firm’s Manchester office at (603) 628-1256 or matthew.whitehead@mclane.com.