Many of our cannabis clients are raising money right now. Out of state investors looking for a place to deploy capital are looking hard at Oregon (which recently abolished residency requirements to participate in its cannabis industry), and some are already starting to lay the groundwork for pending recreational legalization in Nevada and California. Even more established markets, like Washington and Colorado, are seeing an uptick in corporate entities trying to bring in new money. This being the case, now is as good a time as any to do a few posts on the basics of raising money. To start at the beginning, we’ll look at a basic question: debt vs. equity.
Startups are in a different position from existing businesses in determining whether to offer debt or equity. Equity, or convertible debt, is standard. Debt is generally tough to get without signing personal guarantees or taking out a home equity loan or line of credit. These are big personal risks that many entrepreneurs are smart not to take. Fixed payments can also cripple a young business that would be better off reinvesting every dollar it brings in. Still, debt has the advantage of keeping all of the business upside in the hands of the founders.
It is more common for startups raising capital to issue equity. Generally, a founder is looking at handing out 25% – 40% of the shares of a corporation or membership interest in an limited liability company (LLC) in exchange for a significant investment. This isn’t because valuation necessarily points in that direction — it is because investors in small closely held businesses are most enticed when they are able to get a significant percentage of equity in exchange for their investment. A 5% stake just isn’t enough to get much interest from someone buying stock or investing in an LLC. Valuation isn’t an exact science, but if you’re a new retailer looking to raise $500,000 for buildout expenses, you’ll have the easiest time finding money if you can reasonably assert that your business’s post-money value is about $1,500,000. In the marijuana world, a lot of that depends on what state you’re in. The fewer licenses a state issues, the higher pre-money value a startup can claim.
Valuation problems are why there are a couple of hybrid solutions. For businesses that anticipate raising additional money in the future, convertible debt and alternative equity schemes are common. Convertible debt is relatively straightforward. A business issues a promissory note with a 2 or 3-year term. If the business raises more money during that term, the holder of the note gets to convert the debt owed to it to a number of shares issued based on the company’s valuation in that subsequent fundraise, often at a discount. If no money is raised within that period, the holder of the note can either get paid interest and principal on the note, or convert it at a previously-agreed upon valuation. It’s a way to raise “equity” while kicking the valuation can down the road.
A different way to do that is through an alternative equity financing, where the investor puts cash into the company but gets stock or LLC membership interest at a later time, in connection with a future event. That later event can be another fundraising transaction, or it can be some agreed on target. One major difference between this route and convertible debt is that the company never actually issues debt. It gets to avoid debt regulations, like California’s Finance Lenders Law. There is no chance for a maturity date and a mandatory payback.
The main points the issuer and the investor negotiate in both the convertible debt arrangement and the alternative equity financing arrangement include the following
- Is there a valuation cap that protects the investor from getting a minuscule stake in the company if a later investor thinks the company is worth a fortune?
- Is there a discount, so the investor gets some extra credit for being there first?
- What targets, either later equity financing or something in the business cycle, will cause conversion and issuance of stock?
- If there is conversion without an equity financing, how do we determine business value at that time?
All of this can get very complicated, but there is one lesson we have seen proven true over and over and over through the years: Don’t raise money if you don’t need to. If you can bootstrap your business by using your own money and keeping your costs low early on, you will thank yourself in the future. You keep all of your equity and you avoid debt and you avoid having to explain yourself to new participants.
If you do raise money from outsiders, be sure to protect yourself. There are a ton of ways venture capital sharks can take advantage of you. Make sure you stay vigilant.