Pros And Cons Of Debt And Equity Financing - As the cost of capital increases, how do you evaluate and determine the best financing option for your company?
The VC industry (or should) say: "Pay me the price of your title, and I'll give you a job." The idea here is that the founder thinks in terms of value and reduction, while the entrepreneur is more interested in knowing the size of the minimum return and the return on more.
Pros And Cons Of Debt And Equity Financing
In a normal market, investors sometimes, but rarely, use contractual terms—such as dilution preferences greater than 1x, warrants, and anti-dilution clauses— to invest the amount that the founder wants, but according to the conditions that are suitable for the investor. In down markets, where the cost of capital is higher and values are lower, these innovations—that is, jobs with non-standard clauses—are more likely, as they seek create ways to avoid raising money at less than the price per share. Your previous round (ie, down).
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We aim to understand the different strategies that startups use to increase core values, how investors think and use those terms, and the implications, especially for dilution. right, to consider before signing on the dotted line.
In practice, various options and words can be combined, and in the following sections, we will compare specific words and common features that are used to sweeten the right requests. For simplicity's sake, we'll look at four high-level options: Preferred Standard Method, Custom Method, Variable Rate, and Exchange Rate. These options can be considered on a spectrum that trades capital costs and leverage for flexibility.
At the equity end of the spectrum, equity preferred by the standard rather than stock is the most common equity structure for private equity investors. When a person receives a "white paper", this means a formal equity and 1x non-exempt investment interest (more on investment interest in the next section). At the other end of the spectrum, non-revolving credit limits the borrower's rate of return, thereby creating a "clean balance sheet," albeit a more complex balance sheet. (You can see our guide to extending loans and loan terms here).
In the middle, the construction of equity and convertible debt is called "dirty term paper" because it adds contractual terms that make the deal sweeter for investors, such as conditions for increased growth, and guaranteeing the lowest prices.
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The clauses and actions that have been created, even if they are called "dirty," are not good or bad, we are not here to tell the creators what is the right way for their business. However, we want founders to understand the trade-offs that come with structured contracts. With a term sheet—up or down—the founder is focused on value. If one raises the same amount of capital in the same manner, but at a higher price, the fund will be less diluted for the shareholders.
It can be composed in upward rounds, but it is considered a way to reduce the values that have fallen from previous rounds. For example, a founder may accept a "clean" word sheet for a 40% discount, or accept a custom-made flat roll. Most employees, customers and partners don't understand the structure, and a flat circle sounds better than 40% down.
In fact, the best financing option comes from striking the right balance of value and leverage to ensure incentives between your lenders and your board, founders and employees. Here, we explore some of the common flavors used to boost keyword values and how they affect stakeholder dilution and alignment.
What it is: Warrants are one of the most common ways investors and developers change the structure of the operation in the flat area. Warrants (or options) give the investor the right, but not the obligation, to buy the company's shares at a set value before the expiration date, which may be several months from now. to ten years. The training fee can be as little as one penny (or a fraction of a fraction), and is called a penny warrant or issued at face value.
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Why: The training fee is the mainstay of increasing values, but the lower the authorized investment fee, the more likely the dilution. Penny warrants are essentially free additional shares in the company that reduce the "real" price of the round.
What it does: In secondary financing, investors buy stock from shareholders. This is different from the first loans, where the company issues a new loan to pay for the money on the company's balance sheet. Investors can buy the shares they prefer at a higher price in primary and secondary securities (often common stock without protection) from a previous investor at a lower price.
Why: Buying discounted secondhand goods lowers the average purchase price for the investor. Generally, the second payment is mixed with the first so that the effective payment to the investors is lower. As a higher premium is issued and the current stock is sold at a lower price, this can increase the capitalization and reduce the dilution. However, the second has fewer protections for the investor, and who is the buyer, can be interpreted as a bad sign. For example, if the founders are buying shares in a secondary transaction, they are reducing their own rights at a discount to the nominal value of the capital.
In some cases, investors' demand can be adjusted in such a way that capital invested in secondary purchases reduces the amount available for the first. Therefore, for companies that need lower capital, they may prefer the first scheme to the second.
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What it is: The cost of converting a convertible loan into equity. Basically, this is the killer price for the borrower. The conversion price is a value cap, a discount to a preferred financing round, or a token to the IPO (eg the debt converts to a 20% discount to the IPO price).
Why it's important: A bridging loan allows lenders to participate in the company's growth while being paid as a loan (with interest) under very favorable conditions. Most manufacturers want to set the conversion rate as high as possible, such as a round rate, to reduce churn.
What it does: An anti-dilution clause, like an IPO ratchet, protects investors from the current round's overvaluation by giving investors more shares if they fail. the price of the future round or IPO below a predetermined level.
Why: For investors, dilution-resistant bonds provide greater protection for capital gains. If the value is rejected later, especially in an IPO, they will be given more shares to create different or different shares. If values fall, this translates into (significant) dilution for producers and other vulnerable shareholders. Almost all mutual funds have price-related anti-dilution protection, but "ratchet" protection—where all investors are covered from a future down or IPO—is usually found in manufacturing.
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What it is: The need for liquidation specifies who will be paid first in case of damage and how much. Seniority determines the order in which investors are paid, with the most senior paid first—which is safer.
The number refers to the number of original investments that must be paid before the smaller investors are paid. Usually, investors get 1x multiples, so they get their money back before investors get it. However, the number of investment preferences can be greater or less than 1x.
The need for cancellation can also be inclusive or non-inclusive. A non-participating preference gives the investor the greater of the underlying stock preference or the value of the company's stock. Financing interest is the financing interest and the value of the company's real estate, if any, after its interest is paid.
For example, suppose a company is valued at $1B and an investor has a 1x cash preference participant who invests $100M and 20% of the shares. At the time of the sale, the investor will receive the first $100M and the remaining $900M. After that, they will receive 20% of the $900M according to their real estate ownership - for a total of $280M, or 28% of the total equity value.
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Why: The need for cancellation is especially important in downsizing situations. If the company exits at a rate greater than the price per share that the investor pays for the preferred stock multiplied by the number of preferred stock options, that preferred stock is converted into stock. only, and if it doesn't come in, it won't affect the money you get. Ordinary bankers. However, if the company exits at a low price per share or in the worst case of bankruptcy, the investors will get back their investment (or part of it) before the shareholders get any money.
Most "clean" funds claim that they are all investors
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