What are the Different Types of Investments?

The type of investment you take in your business will have implications for many years. Investments are generally broken into three types: equity (in which you receive capital in exchange for ownership of your company), debt (in which you receive capital that you have an obligation to repay but do not give up any ownership in your company) and convertible debt (which is the same as debt but is converted into equity based on some triggering event).

“The type of investment you take in your business will have implications for many years.” 

Equity

As the bread and butter of startup capital, equity is a common investment vehicle that involves individuals and firms providing money in exchange for an ownership percentage (shares, stocks) in a company. This equity can then be sold by the investors at an exit event when a company goes public (IPO) or gets acquired by a larger company. While equity financing entails the loss of some ownership, raising capital in this fashion can be beneficial for entrepreneurs who do not expect to generate revenue that can be used to repay loans or reinvest into the company. Additionally, investors provide critical resources such as networks and valuable advice. Equity is typically secured from angel investors or venture capital firms.

Equity capital is typically raised via numerous “rounds” of financing based on the company’s development stage and needs. The most common rounds include:

• Seed. Seed financing, as the name implies, is the relatively small amount of money a business needs to get started. Usually businesses seeking a seed round are still in the concept stage and need just a small capital to cover expenses until they can start earning revenue. Seed money can also be a helpful tool for attracting future money from bigger investors. Because seed capital is smaller and more of a high-risk investment, it generally will come from friends and family or smaller angel investors.
• Series A. Series A refers to the first round of stock offered to investors during early-stage rounds. Typical Series A rounds fall in the range of $2-5M, offer options for 20-40% of the company, and are intended to support a company through the early stages of building a business, from product development to hiring to marketing. Because the Series A round is for more significant cash, investors are usually professional angel investors or VC firms who specialize in this first round of financing.
• Series B. Series B refers to second-stage financing. Series B usually happens after the company has already achieved certain business milestones and thus proven its potential viability as a company. This series is also sometimes called a venture round since it is at this point that venture capitalists usually get involved. Venture capitalists don’t just offer a greater capital investment for a given round; there’s also a greater possibility for going back to this same well for future rounds. Also, experienced venture capitalists can offer the kind of networking opportunities and mentorship that smaller angel investors may not.
• Series C. As companies grow, they might continue to seek additional funds to meet future milestones. Each successive venture round follows alphabetically down the line (e.g. C, D, E…). Venture capital firms and private equity investors support these financing rounds as well as future funding rounds.

Debt (also called Loans)

Another form of capital is debt, which involves receiving money that must be paid back with interest over a certain period of time. Debt financing is attractive for startup founders who wish to maintain company ownership. Moreover, debt interest payments are tax deductible. But the obligation of repayment can be cumbersome for certain business models. For early stage companies without cash flow, revenue projections, or a business model to be analyzed as a credit risk, it may be difficult to convince lending institutions to give out loans. However, SBA loan programs and debt crowdfunding are tools that can be leveraged for entrepreneurs that have difficulty obtaining traditional bank loans. The most common type of debt financing are:

• Traditional Loan. Just like you would borrow money to buy a house, these loans involve you receiving money and the obligation to pay it back over a period of time (called the term), to pay a certain amount of interest on that loan (called the interest rate) and that has to be paid back in full on a date (called the maturity date). Loans are often secured for some collateral that is security for the payback of the loan. In early stages, founders may also be asked to sign personal guarantees in connection with traditional loans.
• Venture Debt. Venture debt is a type of debt financing provided to venture-backed companies by specialized banks or non-bank lenders to fund working capital or capital expenses, such as purchasing equipment. Unlike traditional bank lending, venture debt is available to startups and growth companies that do not have positive cash flows or significant assets to use as collateral. Venture debt providers combine their loans with warrants, or rights to purchase equity, to compensate for the higher risk of default. A complement to equity financing, venture debt is generally structured as a three-year term loan (or series of loans), with warrants for company stock. Typically, venture debt is senior debt that is secured by a company’s assets or by specific equipment. Overall, venture debt is a form of “risk capital” that is less costly than equity when structured appropriately.
• Accounts Receivable-Based Credit Lines. If your company has sales this can be a great funding option. When you have a sale and create an invoice that needs to be paid by a customer, you create an “Accounts Receivable.” This is a right to be paid. Certain lenders, sometimes called “factors”, will advance you money against that receivable. So if you have an invoice for $100, they will advance you $90 and then they will collect the $100 when your customer pays. This is a quick was to generate capital but can be very expensive. You are essentially taking out a loan on payments yet to be paid.
• SBA Loan. These are bank loans guaranteed by the Small Business Administration (SBA), usually with a lower interest rate than that of loans not guaranteed by the SBA. This guarantee doesn’t mean that you are off the hook if your business fails; in the case that your business goes south, you still need to pay back the loan. The main advantage to this type of loan is access: with the backing of the SBA, you might be approved for loans that you wouldn’t have received otherwise.
• Asset Loan. This is essentially a loan that is secured by collateral (e.g., equipment, inventory). If you need a significant amount of capital equipment, you can finance these purchases. This kind of loan doesn’t always require that the asses you are purchasing is specifically tied to the funding you receive. Sometimes you can even use this loan to fund growth in other areas. This kind of debt is pretty hard to get so we don’t see it too often, but it’s worth seeking out if you have collateral.

Convertible Notes

A convertible note is a hybrid – it is a short-term debt that automatically converts into equity upon future events in a company’s life, such as a later round of financing when a valuation is established. For situations where you do not want to set an equity valuation (to not impede subsequent financings from other investors), or you simply want the option of potentially paying back the cash, for a period of time prior to taking in permanent equity capital, a convertible note is the way to go. A convertible note is a hybrid, part debt and part equity, where it functions as debt, until some point in the future, when it may convert to equity at some predefined terms. Convertible debt is typically secured from the same angel investors and venture capitalists that fund equity deals and is usually used for smaller rounds of financing at the early stages of a company’s life. As a very popular type of startup capital, startup investors are very familiar with this method and may be attracted by lower closing costs related to documentation and associated legal fees.

Grants

Grants (i.e., from startup competitions) are great ways to obtain supplementary funding for a startup since money is provided free of charge. While grant opportunities are difficult to locate and secure, startup competitions are held frequently by numerous organizations across the country. Winning a startup competition not only enhances a company’s credentials and publicity, but also provides a decent source of additional funding for bootstrapped entrepreneurs. A startup can end up using a combination of the above depending on its stage of growth and capital needs.

There really is no optimal type of startup capital that an entrepreneur should target, as it all depends on what’s most suitable for a particular startup’s situation. It is critical to analyze the distinguishing factors of each and determine what’s most beneficial for your company. Raising capital might not be the sexiest task for many startup founders, but it’s a critical component of startup life and definitely requires a certain level of preparation for many startup companies.