Two startup accelerators, Y Combinator and 500 Startups (the "Accelerators"), are changing the way companies raise capital. Ask anyone starting a company how they plan on raising capital and you will often hear talk about taking out a loan. While there are different versions of a loan, the three main components include a lump sum disbursement to the borrower, a repayment with interest, and a date on which that repayment must be made to the lender. While this is great for banks, what about lenders that aren’t interested in a short term, immediate return of their investment? For investors wanting a piece of the company and willing to lend money (used interchangeably herein as Lender and Investor) and for borrowers willing to provide future equity in their company, these loans can cause a number of problems.
First, loans have to have a maturity date. Essentially, the loan must be repaid on a certain date and to extend that loan, the lender and borrower must renegotiate a new loan every time they want extend that maturity date. These renegotiations add additional costs to both parties and don’t move them any closer to their end goal of providing the lender with equity in the company. Second, these loans create an artificial pressure to begin selling equity in the company and getting rid of the loans before it makes business sense. Third, these loans are prolonging the negotiation on valuations of the company.
Now, two startup Accelerators created and generously shared with the public a new agreement that avoids a number of these challenges. These new notes allow the borrower and Investor to negotiate a valuation cap, disburse the money to the company, and then wait. What they are waiting for is a triggering event. So how does this help?
These are not loans, the amount borrowed is not accruing interest and does not have maturity date. This means neither the Lender nor the borrower need to hire attorneys to renegotiate the terms of the loan near the maturity date. Even if the terms were to stay the same, these renegotiations can use up time and money without providing additional value to either party. Instead of an interest rate, the Investor is receiving a valuation cap. In essence, a valuation cap limits the top price an Investor will pay for equity in the company. So when is the Investor allowed to buy equity in the company?
While the trigger events are stipulated within the agreement, an "equity event" triggers the right of the Investor to receive his or her equity in the company. Equity events are situations where the company is providing equity in the company to another person. At the point equity is being offered, the equity in the company is valued and the original Investor can decide whether he or she will pay the valuation price, or will use the valuation cap offered in their document to receive the lowest price. At this point, the Investor can use the money previously invested in the company to receive his or her equity in the company.
After the trigger event, the original document is not needed, as the equity has been disbursed to the Investor and the Investor’s capital contribution has been recovered through ownership of the company. While this trigger event will finalize the transaction, there is not a "maturity date" or a forced trigger date. This is what allows the company to grow without incurring additional fees for the Investor or the borrower, and what will hopefully lead to a lucrative relationship between both parties.
If you would like more details about these and other ways to raise capital, please do not hesitate to call our office. If you would like to speak with the author directly, attorney Christopher Williams can be reached at (847) 705-7555 or email@example.com.