Startup Bonds
An Alternative to VC Funding for Technology Startups
The entrepreneur, under the guidance of an attorney that is not wedded to the VC-Preferred model could create an investment structure that leaves control of the Company with the founders and the common shareholders. However, this may not be acceptable to VC’s and may only be a realistic option currently for smaller rounds of funding.
Note with warrants
Klein, in his paper “The Convertible Bond: A Peculiar Package”[1], explains that a convertible note is ‘basically a debt financing, with the conversion privilege as a “sweetener”. He argues that a better alternative is to issue a bond with warrants—rights to acquire common stock.
Instead of conversion, the startup investment could be structured as a note accompanied with warrants to acquire common stock. The note will be redeemed in case of acquisition or liquidation, but the warrant could provide the holder with the right to purchase common at a preferential, pre-defined, price and participate in the upside potential.
Like a convertible note, the warrant doesn’t carry fiduciary duties or control power unless it is exercised. In addressing whether warrantholders were entitled appraisal rights in a takeover situation, and deciding in the negative, the Court in Aspen Advisors LLC v. UA Theatre Co[2]., confirmed that the Company does not owe fiduciary duties to warrantholders: “A warrantholder is not a stockholder… A warrantholder is only entitled to the rights of a shareholder.. after they (convert) to stock ownership”. The Court in Aspen also confirmed that the rights of warrantholders and preferred stockholders should be construed narrowly by the Courts: “Warrants are contractual entitlements. The exclusive rights and remedies of warrantholders must appear in the contractual provisions of the warrants.”
Klein’s discussion of the warrant structure as superior to the convertible note fails to properly address the cash flow concerns of the startup entrepreneur and recognize that the convertible note is an either/or model where the warrant is not. The entrepreneur with a convertible note either redeems the note or converts it to common. Under the warrant structure, the warrants remain after the note is redeemed. If the investor converts the convertible note to common stock, then the Company is not required to redeem the note. This is a significant cash-flow advantage to the entrepreneur and the convertible note may remain the better alternative for the startup entrepreneur.
Guaranteed credit facility
In many countries bank debt forms the most significant source of startup financing. However, in the U.S. venture capital is more prevalent and many startups have difficulties raising bank debt. Credit facilities are offered by U.S. banks but collateral is a problem for most technology startup entrepreneurs as the only asset available from the Company is usually intellectual property. The entrepreneur seeking a bank facility is usually forced to provide his/her house as collateral or have the loan guaranteed by another.
Instead of asking an investor to put cash into the startup company, the entrepreneur could ask the investor to act as guarantor. The advantage for the investor is that he/she can retain the cash for other purposes. The advantage for the entrepreneur is the lower interest rate payable to the bank, and with an overdraft facility there is more flexibility on the amount borrowed. The disadvantage when compared with equity financings (involving the sale of shares) is that the loan has to be repaid to the bank, with interest.
Of course, as the bank is acting as a lender, no fiduciary duties are owed to the bank by the management of the Company. The bank is clearly a creditor, but warrants to guarantors may trigger fiduciary duties unless the warrant are restricted from being exercised until a liquidity event like a sale of the Company.
The issue for most entrepreneurs is finding the guarantor. Perhaps several individuals, or organizations, could guarantee the facility. In the situation with multiple guarantors the question would arise as to who would be held liable if the Company were to fail and the debt remain unpaid. Perhaps the joint guarantors would be held jointly and severally liable. Currently, the banks in the U.S. do not offer a wide range of financing options for technology startups and refer entrepreneurs to the VC community. The banks dealing with small businesses tend to focus on SBA loans.
SBA loans
The Small Business Administration (“SBA[3]”) was established on July 30, 1953, by the United States Congress with the passage of the Small Business Act. Its function was to "aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns." Also stipulated was that the SBA should ensure a "fair proportion" of government contracts and sales of surplus property to small business. This was accomplished primarily through the Small Business Innovative Research program and government "set-asides."
The SBA itself does not grant loans to startups. Instead, the SBA guarantees against default certain portions of business loans made by banks and other lenders that conform to its guidelines[4]. The SBA loan guarantee is only available to small businesses. What qualifies as a small business depends on the industry and sector[5].
Repayment ability from the cash flow of the business is a primary consideration in the SBA loan decision process but good character, management capability, collateral, and owner's equity contribution are also important considerations. All owners of twenty percent (20%) or more of the business are required to personally guarantee SBA loans. The SBA does not deny approval for a SBA Guaranty Loan solely due to lack of collateral; however, it can be used as a reason, in addition to, other credit factors.
The SBA has directly or indirectly helped nearly 20 million businesses and currently holds a portfolio of roughly 219,000 loans worth more than $45 billion making it the largest single financial backer of businesses in the United States. The size of loan available through the SBA program ranges from $150,000 to $4m, but the SBA will only guarantee up to $1.5m.
Entrepreneurs and founders holding significant blocks of shares have to put their own assets on the line as personal guaranties are required by all owners holding 20% of the Company stock. SBA loans are criticized as equivalent to or many times worse than what the banks offer themselves, so a customer of that bank might choose the normal bank product more often than their SBA product. However, like a bank loan the SBA loan is pure debt, so fiduciary duties are not owed by management to the bank, or the SBA, so the entrepreneur does not gain rights to board seats, voting rights or other forms of control.
An SBA guaranteed loan is a viable alternative to venture funding for entrepreneurs that wish to retain control of their startup companies, however, it is a huge commitment as it usually means providing the entrepreneurs own personal assets as collateral.
[1] 123 U. Pa. L. Rev. 547. 558-68 (1975).
[2] 861 A.2d 1251.
[3] http://www.sba.gov
[4] http://www.sba.gov/smallbusinessplanner/start/financestartup/SERV_SBA_LOAN_TOPICS.html
[5] The SBA uses the North American Industrial Classification System (NAICS) in determining size standards.