Is it just me, or did every basketball coach ever go on and on about “back to basics” and “focus on the fundamentals,” as though Steph Curry hadn’t just inspired an entire generation to lob threes from half-court (and miss – because, you know, they’re not Steph).
While it isn’t sexy or flashy, fundamentals for a skill, practice, or strategy are important because they lay the foundation for future success. For microinvesting, it pays to both know and understand some fundamental components of an offering — starting with what types of offerings are there and how do they differ?
There are a variety of offering types a business owner can choose from when doing a raise. Let’s look at some popular ones through Reg CF:
What’s a Revenue Sharing Note?
A “rev share” is a debt structure that works like a royalty payment. The business pays a set percentage of their revenue until the investor is paid back a “multiple” of their investment. For example, a business may agree to pay 5% of their revenues each quarter until investors make 1.5x (the multiple) their original investment. As an investor, you would expect to turn a $1,000 into $1,500. The amount of time it takes to pay is dependent on the business’ revenue.
The beauty of a rev share is in its simplicity and flexibility. A business knows exactly how much they will pay out, but their growth rate will determine how quickly they pay it back. And for the investor (that may also be a customer) – this is one of the coolest “cash-back” rewards programs I can think of!
What’s a term loan?
Exactly what you’re used to in a loan. Regular payments (likely quarterly in this case), a set interest rate and a maturity date dictating when the loan ends. A pleasant surprise with Vicinity is that ours typically don’t come with personal guarantee requirements or specific collateral against the loan.
This is a way for a business to let their community be their bank, with the benefit of turning your investors into local brand ambassadors. Similar to a rev share, this is a non-dilutive way (i.e. not giving up any ownership) for a business to raise growth capital. Either of these can work well for a business that is in a position to make debt payments and is not necessarily looking for an exit/sale.
What’s a SAFE?
This is where investors place their money in an airtight, fireproof lockbox that is only accessed when…just kidding.
A SAFE is a Simple Agreement for Future Equity – meaning the business is simply agreeing to give investors equity…in the future. Easy, right? That’s the idea. This is often used by early stage startups because it delays the challenge of determining how much the company is worth. The number of shares an investor receives is determined at a future priced investment round, typically with professional investors. Therefore, it only has value if the startup raises capital in the future. When they do convert, the SAFE investor typically gets a lower price per share than the professional investors since they invested earlier.
The share price for a SAFE holder is determined by a Valuation Cap and/or a Discount Rate, making these the really important parts of the agreement!
The valuation cap sets the maximum price on the stock. For example, if a valuation cap is set at $3 million and the company later raises at a $6 million valuation, the amount of stock an investor gets will be priced off the $3 million. If the raise valuation is $3 million or less, then the stock price is set off the actual valuation.
The discount rate simply applies a discount to the share price for SAFE holders as compared to the future investors. For example, if the shares at a future priced round are $5 per share, a 20% discount rate would convert the SAFE holder shares to equity at a price of $4 per share ($5 * 80%).
As an investor, remember, the lower the share price at conversion, the more shares you get. The valuation cap and the discount rate give you the opportunity for cheaper shares for taking the risk of investing earlier.
What’s a convertible note?
Also a popular form of capital for an early-stage startup, a convertible note is an unsecured loan that converts to stock in the future. Similar to the SAFE, these delay the task of determining the value of the company and convert to shares at a future qualified financing round. Also like a SAFE, the conversion is intended to be discounted based on a valuation cap, a discount rate, and also accounts for an interest rate (unlike a SAFE) for taking the risk of investing earlier.
Unlike a SAFE, if another round of funding does not happen, the note becomes due at a set maturity date. If not repaid in cash (which can often be difficult for an early stage company), the note converts to equity at a pre-set target price.
What’s stock or membership units?
These are actual ownership shares in a company. With Reg CF, these will rarely come with voting rights, but do give investors an immediate legal ownership stake in the company. This may result in dividend payments, preferred returns, and appreciation/depreciation in value over time.
Real estate investments and some startups may sell ownership shares to the public through Reg CF. As a part-owner, investors will have different tax implications to be aware of. For example, a tax form called a K-1 will be issued by the company to all owners and will need to be submitted as a part of the investor’s tax filings.
Which one should I pick?
Every situation is going to be different. Whether you’re an investor or an issuer, picking the right offering is a key component to your Reg CF success. And while there is no cookie-cutter formula for deciding on an offering type, the best approach is to research and understand the fundamentals so you can make an informed decision. Investors have the flexibility to choose multiple types of offerings at once, however, based on the regulations, issuers will have to choose wisely with a single type of security for their raise. While details of offering types might not be the most exciting part about funding a local business, having a good grasp of the fundamentals will give you a leg up on choosing your ideal offering type! As always, if you have questions, just drop us a line at [email protected]