Startup Bonds

An Alternative to VC Funding for Technology Startups

Startup Funding for Savvy Entrepreneurs

The existing model of funding startups--through venture capital preferred stock investments--hands control of the company to the investors, significantly dilutes the shares of the founding entrepreneurs and results in the vast majority of startup ventures failing, with significant losses. Although this model has become the standard VC investment structure in Silicon Valley, it is an unusual financial instrument in many ways, and would not be accepted outside of the startup sector, where there is a significant imbalance of power between the VC investors and the founding entrepreneurs. There are alternative investment structures available.

The world market capitalization of bonds is actually larger than that of equity. Where a note is a long term commitment, bonds and debentures are long-term commitments—usually longer than 5 years.

The Preferred Stock Model

Preferred stock is a hybrid of debt and equity offering the best of both worlds—for the investor. Preferred stock is essentially common stock plus additional contractual rights. These rights usually allow the preferred stockholder to control:

  • If company is sold
  • If company raises new funding
  • Appointment of directors
  • Other provisions

Public (Wall Street) investors won’t accept the structure, so preferred rights are eliminated at IPO.

Why Entrepreneurs Dislike the Preferred Model

The preferred stock model is unpopular with entrepreneurs for a number of reasons:

  • The founders lose ultimate control to the investors
  • Management owes fiduciary duties to the investors
  • Ratchets and anti-dilution provisions can dilute the founders
  • Liquidation preferences can harm the founders at M&A

Investor syndication leads to standardization in the way all VC's structure their deals—so there's remarkably little choice/variety in the investments offers made to entrepreneurs by competing VC funds.

Startup Bonds

A Startup Bond is essentially a convertible note or debt instrument that is sold to investors by the company to raise funds. Interest accumulates on the loan over the period.

One or more of the following trigger events enables the loan to be converted to common stock at a pre-set price:

  • IPO
  • Acquisition
  • Liquidation

Redemption

The bond can be structured so that investors can put the note to company for payment after, say, 5 years. Price may be a multiple of the initial investment.

Legal Framework

The SEC and federal securities laws govern the issuing of bonds, as they are classified as 'securities'. This means that the security must be registered (with the SEC, like an IPO), or qualify for an exemption from registration, such as a private placement.

The private placement exemption is available for accredited investor only--individuals or corporations with high net worth or high incomes.

Until bond converts to common stock, management does not owe a fiduciary duty to the noteholders as they would to shareholders--corporate law is for stockholders but contract law is for debtholders.

Some Characteristics of Bonds

Bonds are often issued by governments, but they are issued by all types of organizations, including private and public corporations. Some of the characteristics of bonds are:

  • Senior or subordinated
  • Secured or unsecured
  • Floating or fixed rate of interest
  • Callable or non callable
  • Convertible or straight

Advantage of the Startup Bond

A significant advantage of the startup bond is that the founders retain control of:

  • Board of directors
  • Management
  • Exits
  • Fundraising

The bond is also relatively easy and inexpensive to setup. Simple contracts are required (but the registration exemption and SEC filings are still necessary).

Other advantages are:

  • Flexibility in the amount that can be raise from each investor--as the investors do not qualify for shareholder rights, there's little concern in raising smaller sums
  • Flexibility in when each individual note is closed--not necessary to wait for all investors before taking investment from one individual
  • Liquidation preference provided by bankruptcy law
  • Can be offered to all accredited investors (not restricted to VC’s)
  • Simple syndication to multiple investors

Good Timing for Startup Bonds?
Of course VC's prefer the preferred stock model, but the Startup Bond may become increasingly appealing due to the following trends:
  • Growing sophistication and business skills of entrepreneurs (that don’t need VC’s to tell them how to run a company)
  • Low interest rates
  • Growing number of startups too small for VC funding (that do not want/need $5m from VC’s Lower startup costsInternet marketing
  • Interoperability of technology components and development tools reduces the cost of product development--products are created by assembling components.
  • Growth of private equity funds and other sources of funding

Resistance from the VC Community?

Investors prefer the preferred model as it offers more control to VC. But law firms have also become attached to the preferred model--it helps lawyers win business from VC's. Lawyers seldom question the appropriateness of the preferred stock model for startup clients and some will resist the move away from preferred stock.

Startup Bonds—Other Effects?

The emergence of Startup Bonds as funding instruments for startup companies could go hand-in-hand with a new portfolio model for participating investors. This may involve an investor making a larger number of smaller investments and taking a passive role when it comes to managing the company. A $1bn fund may translate into several thousand startup investments while it currently translates to less than 100 investments using the prevaling VC business model.

This form of investment may lead to more innovative new technologies coming to market, and more hot new products being acquired and marketed by large corporations with existing routes to market.

Currently, the VC model relies upon a small number of 'home run' returns from the portfolio of investments--so VC's often use their preferred stock control rights to veto company sales if they are less than $500m. Under the Startup Bond model, the veto rights may not exist and the decision to sell will rest in the hands of the founding entrepreneurs and other common shareholders. This will result in acquisitions offers of $100m or less being accepted by startup companies--and more products being acquired by large corporations looking for new products and revenue streams.