Debt, Equity, Seed, Series A, Etc.
Ask Sherman
October / November 2009
Volume 7 Number 5
If you're a prospective or actual technology entrepreneur, you may have a question about what to do—and what not to do. Sherman McCorkle is president and CEO of Technology Ventures Corporation, which has been helping entrepreneurs for more than 15 years. He'll answer your questions in this space.
I am confused. What is the difference between debt and equity funding?
A great question. Debt funding is the traditional method of money-lending, familiar to anyone who has ever made payments on a car loan or a mortgage. A lending institution provides funds to borrowers that are repaid over a fixed period of time. The lender's benefit from this type of loan is the interest paid over the period of the loan. These loans are often collateralized against a real property, like a car or a house, which has some value in case the loan cannot be repaid.
Equity funding is provided in exchange for ownership in the business. The ownership in this agreement are shares of stock. The investors can be qualified investors, equity capital funds or sometimes, friends and family members. The benefit to these equity investors is only derived at the time when the stock ownership in the company becomes saleable, or liquid, through a public offering or sale of the company.
So which one is right for me?
Both types of loans have benefits and drawbacks. I call them loans because the lenders do expect to get paid back, one in the form of interest, the other when they can sell their shares of stock. This difference in payback methods provides some insight into the benefits of each.
Debt funds are paid back at a predictable, calculable rate. These loans are widely available through banks and other lenders and there is a competitive market for your business. The loan often requires a guarantee of payback, usually against a tangible asset. If your business does not have any tangible assets, the lender may ask for a guarantee against your personal assets such as your car or your home. If you do not meet your repayment obligations, the lender can take and sell these assets to help with repayment.
According to a national survey, less than 10 percent of businesses receive funding through equity sources. This is due to two factors. First, equity lenders usually have a very narrow lending criteria based on the market segment in which their investment companies operate and second, there are not as many equity lenders out there. To receive money from an equity source you must be able to reasonably prove that your business has a chance to get to a point where it can be sold or taken to the public markets. This is usually done in the form of a business plan.
The drawback comes from the fact that the equity partner does own part of your business and therefore may have some rights when it comes to the direction of your company. This is not always bad but can be a point of contention if not properly managed.
Seed, Series A or Series B or Mezzanine?
I know it sounds like your seat selection choices for a night at the opera but these are actually different equity funding stages. Depending on the stage of your company, and the amount of money that you are seeking, different equity funding sources will be available to you.
Early in your company's existence, while you are trying to prove your concept, your company might be of interest to a seed equity investor. These early investors typically look to invest between $100k to $1M in companies who need the funds for early startup costs such as building a prototype or test marketing a product. These funds will come in through a series of tranches, a fancy French word for slices, tied to milestones in your development.
Similarly, as your company matures toward product release and hopefully market domination, different equity sources may become available to you. These are named sequentially, starting at "A." Equity funding sources typically have a preference for a given stage of a company's maturity and this may influence at which "series" they will look to invest. As an example, a Series A investor may look at companies who are launching there beta product into the market, where a Series B investor may wait until a company needs funds to expand its sales focus beyond a market in which a company has already created a strong presence.
The last of these, Mezzanine funds, refer to equity funds provided for major expansion of a company that is already profitable, or at least breaking even. Many times these funds are used for manufacturing expansion or a new product launch.
So all four are simply types of equity funding and your access to these different types of funds is a function of your company's stage of development. That still doesn't explain, however, why the financial community is the only one that uses the word tranche.
Write Sherman at sherman@innovation-america.org
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