“I have developed the next groundbreaking software tool, but how can I obtain funding in order to grow this innovation?” This is an all-too-familiar thought of every entrepreneur. Obtaining funding for a start-up organization can be one of the most painstakingly hard processes that an entrepreneur can face. In some instances, obtaining financing to continue on the journey can be more difficult than cultivating the idea you are trying to commercialize.
Most entrepreneurs are focused on their big idea and are not typically focused on the intricacies of the various levels of funding to grow their company. Below is a synopsis of the five major levels of funding:
1. Seed Funding: Seed funding can take various forms. The most common is crowdfunding. Crowdfunding can come from family, personal friends, or strangers. Crowdfunding sites such as Kickstarter and gofundme have become extremely popular over the past several years. Seed funding provides a cash benefit for the entrepreneur in exchange for equity or convertible debt. Convertible debt allows a debt instrument to be converted into a specified number of shares of common stock. In accordance with Accounting Standards Codification (ASC) Section 480, Distinguishing Liabilities from Equity, the characteristics of the convertible debt are analyzed to determine if the debt should be bifurcated with a portion of the financing allocated to the debt instrument and the remaining portion allocated to the conversion feature.
2. Angel Funding: Angel funding has similar characteristics to seed funding; however, angel investors are private, accredited, high-net-worth individuals. Angel investors often provide business advice and consulting but do not always require an equity interest in the company.
3. Venture Capital Funding: Venture capital funding is a form of financing that requires an equity interest in the company. The first round of venture capital funding is the Series A round. Series A typically takes the form of preferred stock. The most common characteristics of Series A preferred stock include conversion options into common stock and liquidation preferences. Common conversion features may be at the option of the preferred stockholder or mandatory with the approval of the majority of the stockholders. In addition, preferred stock agreements usually include a provision that will mandate conversion if the company consummates an initial public offering at a designated price with specified proceeds. Voting rights for preferred stockholders may be equal to common stockholders or may be preferential to common stockholders. Additional funding, including Series B and Series C rounds, usually occurs at the venture capital level.
Two additional features that are commonly issued in conjunction with Series A are the creation of a stock option pool and issuance of warrants. These can be issued at the seed levels also; however, they are more commonly issued once a company has obtained venture capital funding. The stock option pool will be established to offer both qualified and nonqualified stock options to purchase common stock. Qualified options can be issued only to employees; whereas, nonqualified stock options can be issued to employees, vendors, board members, consultants, etc. Upon issuance, the stock options are valued at fair value in accordance with ASC 718, Stock Compensation. The most common technique for valuing stock options is the Black Scholes model. Warrants can be issued in the form of detachable or nondetachable warrants. Warrants provide the right to purchase the underlying stock at a discounted amount.
4. Mezzanine and Bridge Loans: Mezzanine and bridge loans are usually entered into prior to an initial public offering. The goal is to provide help in order to meet the next level of funding. Bridge loans can also be used in between various series of funding at the venture capital level.
5. Initial Public Offering: An initial public offering (IPO) is the ultimate exit that entrepreneurs strive towards. There are both advantages and disadvantages to this type of an exit, including raising money, having the company’s shares listed on a stock exchange, incurring expensive costs, and adhering to more regulations.
By understanding the various levels of funding, entrepreneurs will have the information to be able to face the challenge of how to obtain funding. Please contact the Schneider Downs Audit and Assurance Department for additional information regarding funding for start-up companies or visit the Our Thoughts On blog for similar articles.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.