Budding entrepreneurs hunting for financing often drop into my office to ask about what they need to do to raise capital. I generally outline the following steps.
Step 1 is to decide the form of ownership: sole proprietorship, general partnership, limited partnership, corporation, S corporate, professional corporation or limited liability company. This decision is a complex one driven by tax considerations, the number of investors, exit strategy, licensing requirements, employee withholding taxes and a variety other factors. A very helpful booklet, "Doing Business in Utah," discusses these issues and other requirements. It is available at the Utah State Tax Commission.
Step 2 is to determine how much capital you need and when you need it. This requires preparing "pro forma" (forecasted) financial statements.
Step 3 is to value the company to determine how much of it you will need to give up for the financing.
Step 4 is to determine the most appropriate financial instrument for the potential investor. If the business is simple and low risk, then perhaps a loan is most appropriate. But for most new startups the high risk, the lack of collateral and the up-front negative cash flows usually force the investor into some type of equity or equity-linked financial instrument.
One of the most popular forms for venture capital (VC) financing is convertible preferred stock. Convertible preferred pays a regular dividend and may be exchanged for common stock at the investor's option, subject to the terms of the agreement.
There are several reasons why both VC firms and entrepreneurs like convertible preferred. One reason is control. Usually each round of financing will be for less than 50 percent of the company. VCs who accept common stock will not get sufficient votes to control the company and protect their investment. However, VCs with preferred stock can embed covenants and restrictions in the agreement to protect their position.
Another reason is risk-return management. VCs don't want straight debt because they want the upside potential. Like debt, though, preferred stock is advantageous to common stock in that it is "senior" and lines up before common stock. That means that VCs will get all of their money back before the entrepreneur gets anything. In addition, most VCs will require that entrepreneurs sink a huge portion of their personal net worth into the venture, which may mean taking out a second mortgage on the house and borrowing against the car or other assets. This creates a strong incentive for the entrepreneur to work hard. It also means that the entrepreneur won't walk away when the going gets really tough; entrepreneurs who walk away lose everything.
Finally, there are tax considerations. If the VC is incorporated, the dividend exclusion rule in the tax code allows the VC to exclude 70 percent of the dividends for tax purposes. Usually, the entrepreneur is not hurt by the fact that dividends are not tax deductible, because the company is showing losses and not paying taxes in the early years.
Once the company becomes profitable, convertible debt may be more attractive. If you choose convertible preferred be aware of "participation" and "ratchet down" clauses. The participation clause allows a "double dip" in that investors receive their original investment back and also receive the number of shares of common stock specified in the conversion clause. The "ratchet down" clause resets the number of shares the convertible preferred investor receives if the company in a later round of financing must reduce the value of the company to obtain financing.
In recent months, many companies have had to raise new financing at substantially lower valuations than earlier financings, and entrepreneurs have had their percentage ownership dramatically reduced by these ratchet down clauses.
Good luck in the hunt!
Hal Heaton is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at cfe@byu.edu.