Start-Up Financing 2.0 Seth C. Oranburg Abstract: Entrepreneurs raise money --- or start-ups by acquiring debt, selling stock, mixing the two, and crowd --- unding. This chapter explains the pros and cons o --- those start-up --- inancing options. Start-ups must repay debt on time, which is hard --- or them to do be --- ore they start making pro --- its. Stock investors collect repayment only when the start-up is acquired or goes public, but entrepreneurs cede some control o --- the start-up to stockholders. Hybrid options like convertible debt provide a temporary solution to some --- inancing problems. Crowd --- unding is a new way to --- undraise through peer-to-peer networks, but it works well only --- or a --- ew types o --- start-ups. Entrepreneurs should per --- orm a care --- ul analysis be --- ore choosing a --- undraising option because --- undraising has long-term consequences --- or start-ups. Table o --- Contents 1 Introduction................................................................................................................................. 2 2 Debt --- inancing ............................................................................................................................. 3 2.1 Introduction ......................................................................................................................... 4 2.2 Pros and cons ....................................................................................................................... 4 2.3 Issues .................................................................................................................................... 5 3 Equity --- inancing.......................................................................................................................... 6 3.1 Introduction ......................................................................................................................... 6 3.2 Pros and cons ....................................................................................................................... 6 3.3 Key issues ............................................................................................................................. 8 4 Convertible debt --- inancing.......................................................................................................... 9 4.1 Introduction ......................................................................................................................... 9 4.2 Pros and cons ..................................................................................................................... 10 4.3 Key issues ........................................................................................................................... 11 5 Crowd --- unding ........................................................................................................................... 12 5.1 Introduction ....................................................................................................................... 12 5.1.1 Donations ..................................................................................................................... 12 5.1.2 Rewards........................................................................................................................ 13 5.1.3 Pre-purchase ................................................................................................................. 13 5.1.4 Lending ........................................................................................................................ 14 5.1.5 Equity crowd --- unding ................................................................................................... 14 5.1.6 Venture Philanthropy ................................................................................................... 15 5.1.7 Initial Coin O --- --- erings ................................................................................................... 16 5.2 Pros and cons ..................................................................................................................... 16 5.3 Key issues ........................................................................................................................... 17 6 Conclusions and --- uture trends ................................................................................................. 18 Re --- erences .................................................................................................................................... 19 Electronic copy available at: https://ssrn.com/abstract=2743072 1 Introduction Start-ups are innovative, high-risk, high-growth business ventures that o --- ten require a signi --- icant amount o --- external --- inancing (Vaznyte, 2019). Most start-ups “bootstrap,” meaning sel --- - --- und in their earliest stages, generally through various creative methods designed to reduce the need --- or outside --- inancing, and to minimize the need --- or cash (Ye, 2017). In the early stages o --- a start-up’s li --- e, most entrepreneurs tend to --- inance their ventures using their personal savings (Aydin, 2015). Many start-ups raise --- und through --- amily members and --- riends, whereas less than 1% o --- startups are --- unded by venture capital and angel investors. However, these pro --- essional investors contribute much more money per --- inancing round, so VC and angel --- unds still represent a signi --- icant portion o --- start-up --- inancing on a per-dollars basis. Bank loans tend to be di --- --- icult --- or start-ups to secure, although the Small Business Associations makes debt --- inancing more --- easible. Finally, crowd --- unding is small but --- ast-growing source o --- --- unds. Fig. 4.1 shows the top --- unding sources in a study by the Center --- or Venture Research. Figure 1. Top Funding Sources --- or Start-Ups. As Figure 1 makes clear, most start-up --- unding comes --- rom --- ounders and their --- amily and --- riends, who contribute an average o --- about $23,000 each. However, some business models require massive and repeated in --- usions o --- millions o --- dollars, which is only --- easible to obtain through venture capital. High-growth startups need venture capital like spacecra --- ts need rocket --- uel. Moreover, obtaining --- unding --- rom outside investors such as venture capital impacts the business model and have legal e --- --- ects. Accordingly, this chapter will --- ocus on how start-ups are --- ormally --- inanced by outside investors to grow rapidly. 2 Electronic copy available at: https://ssrn.com/abstract=2743072 Pro --- essional investors --- und start-ups primarily through the use o --- debt, equity, or convertible debt (a hybrid o --- debt and equity) (Deeb, 2014). Crowd --- unding is emerging as a new way --- or start-ups to get outside investments. At the outset, it is important to note that all o --- these methods may involve the issuance o --- securities, which are subject to various laws. Engage a competent attorney in any securities issuance because compliance can be tricky, and penalties can be harsh. Be --- ore a company can issue securities, it should be --- ormed or incorporated. Start-up --- ormation involves two --- ormative decisions that a --- --- ect --- inancing and have repercussions --- or the li --- e o --- the company: In what state should you --- orm or incorporate the company? What type o --- entity do you want to --- orm there? There are many excellent resources about how to make this critical decision – and limited liability companies are quickly growing in popularity. – but most American entrepreneurs who seek venture capital still choose to --- orm a Delaware corporation. This chapter will, there --- ore, --- ocus on start-up --- inancing --- or a Delaware corporation, although it may be help --- ul to understand the reasons why many entrepreneurs make this choice. Corporations are the most common entity choice --- or a start-up because the corporate --- orm is well understood, separates ownership and control, limits liability --- or shareholders and directors, simpli --- ies accounting, can be created quickly and easily, and has many standard characteristics that make it possible to use standard --- orms to issue securities (Hyman, 2014, §1:1). This is not, however, the only choice. In recent years many states have authorized the creation o --- new entity types. The most popular new entity type is the Limited Liability Company, which is lauded --- or its --- lexibility and tax bene --- its (Sargent and Schwidetzky, 2014, §1:1). Flexibility is not always a bene --- it to start-ups seeking --- inancing because complexity and customization quickly increase legal costs, and investors have to review more in --- ormation to understand investors' rights in --- lexible entities. The tax bene --- its may also be illusory, as most start-ups lose money --- or years be --- ore they turn a pro --- it. The state o --- incorporation matters a great deal because the corporate law o --- the state o --- incorporation governs the corporation's internal a --- --- airs (such as voting rules and other shareholder protections), and corporations may be sued in their state o --- incorporation. Most start- ups incorporate in Delaware because Delaware law is generally considered to be the most predictable (Fisch, 2000; Jagannathan, 2017). The Delaware courts are also reputed to be the best in resolving corporate issues quickly and --- airly. Some start-ups choose to incorporate in the state in which they do business because this saves costs, but outside investors --- rom other states may be hesitant to invest in entities that could be subject to quirky state laws. Accordingly, this chapter assumes the entrepreneur will --- orm a Delaware corporation, which is widely regarded as the sa --- est choice --- or a start-up that seeks outside investment, even though there are many good reasons to make other choices. Consult a legal advisor to determine i --- another entity choice or state o --- incorporation is better --- or you. 2 Debt --- inancing 3 Electronic copy available at: https://ssrn.com/abstract=2743072 2.1 Introduction Many entrepreneurs are already --- amiliar with debt --- inancing --- rom their personal li --- e. While debt agreements to borrow money can be very complicated, they have several common and straight --- orward characteristics. The most essential characteristics o --- debt --- inancing to many entrepreneurs are, --- irst, that lenders typically do not have rights to tell the entrepreneur how to run the business and, second, --- ailure to make regularly scheduled debt payment can put the start- up into bankruptcy. 2.2 Pros and cons Perhaps the biggest advantage o --- debt --- inancing is the end o --- the relationship when the debt is repaid and lenders do not have the right to tell the entrepreneur how to run the business in the meantime (unless such rights are given by contract, which is unusual). This is a pro --- or the entrepreneur who wants to maintain total control o --- the start-up. So long as the debt is repaid on time and as scheduled, the entrepreneur does not have to answer to investors. Doing so can even raise the start-up's credit rating, making it easier to borrow money in the --- uture. However, early-stage start-ups o --- ten have dips in cash --- lows that make it challenging to make debt payments every month. Moreover, the entrepreneur may pre --- er to reinvest pro --- its in growing the business, rather than making debt payments. Entrepreneurs may not realize that corporate debt requires regular repayment; severe repercussions can result when payments are missed. When a start-up --- ails to make a debt payment when it is due, the loan immediately goes into de --- ault. However, de --- ault --- or nonpayment is only one o --- many ways in which a start-up can de --- ault on a loan. Commercial debt agreements also have a several covenants, which are conditions that must be met while the loan is outstanding. Financial covenants can include a requirement to maintain a minimum level o --- assets or not to take on more debt. Another con associated with these covenants is that the entrepreneur will have to provide the bank with balance sheets, income statements, and cash --- low documents regularly so the bank can con --- irm that the --- inancial covenants are not violated (Booth, 2014, Chapter 6). Banks may also ask start-ups to agree to operating activity covenants. These can be unobjectionable, like a requirement to pay taxes and comply with laws and regulations, or they can be onerous, like a prohibition against using company money --- or a speci --- ic purposes–such as leasing equipment or real estate, changing management, selling assets, or paying dividends– without bank approval (Booth, 2014, § 6:13). It may --- eel like there is a banker in the boardroom while the debt is outstanding. Fortunately, not all loans are so burdensome. In --- act, another advantage o --- loans is that there are many products --- rom which to choose. For example, the Small Business Association helps start- ups get commercial loans up to $5 million at reasonably good terms (SBA loans, n.d.). Such 4 Electronic copy available at: https://ssrn.com/abstract=2743072 loans can have --- ixed interest rates and long terms, so the monthly payment is low and certain. There is also a new lending industry called peer-to-peer (P2P) lending or crowd --- unding, which does not use a traditional bank at all (see Section 4.5). These alternative (non-bank) lenders are important --- or start-ups because many banks are unlikely to --- und a start-up that does not have su --- --- icient collateral to guarantee a loan. Collateral is property o --- the borrower that can be seized i --- the borrower does not repay the loan. This is o --- ten called a security interest, and it can include cash, real property, and intellectual property. Posting security o --- ten helps the borrower obtain a lower interest rate because it makes the loan less risky --- or the lender, but many early-stage start-ups (and some late-stage ones) lack su --- --- icient collateral --- or a traditional loan (Brad --- ord, 2012; Lee, 2018). 2.3 Issues There are a number o --- issues with start-up debt --- inancing, but perhaps the most signi --- icant issue is that currently, it is hard --- or a small business in America to get a loan, especially without collateral. Small business owners generally have di --- --- iculty obtaining loans (Chakraborty and Mallick, 2012; Belás, 2015). This is particularly problematic --- or the busy entrepreneur. Filling out each loan application can take hours, and the bank may require days' worth o --- --- ollow-up in --- ormation be --- ore denying the loan application. Studies show that the trend away --- rom small business bank lending is unlikely to reverse (Peirce et al., 2014). Fortunately, there are new sources o --- debt --- inancing that put --- ewer arduous requirements on start-ups. The new industry o --- P2P lending has emerged to provide personal and small business loans. Lending Club, Prosper, Realty Mogul, and other companies provide a P2P plat --- orm where borrowers and lenders can transact without going through a traditional bank. Each plat --- orm has its own methods, but generally, the P2P lending works on a reverse-auction model. The start-up creates a pro --- ile and submits --- inancial in --- ormation to the plat --- orm, which assigns a credit rating. Then the start-up posts a request on the plat --- orm's website --- or --- unds. Lenders view potential borrowers and contribute some --- raction o --- the requested amount. Depending on the attractiveness o --- the borrower, it may take some time --- or enough lenders to syndicate and --- und the entire loan amount. Typically, the cash is not available to the borrower until the loan is --- ully --- unded, so this creates an issue i --- money is needed urgently. Another issue with P2P lending is that the request --- or a loan is visible to thousands o --- people, not just a --- ew banks. Some entrepreneurs may not want to disclose their business model and --- inancial situation so broadly. An analogy may be posting a request --- or a personal loan to a Facebook page, something which may not be desirable --- or the entrepreneur. Finally, loan documents, especially ones with security or collateral agreements, are complicated, technical, and hard to read. The loan agreement may set --- orth a large number o --- restrictive covenants, and it can be hard to track when they are breached. The risks o --- de --- ault not only --- or 5 Electronic copy available at: https://ssrn.com/abstract=2743072 nonpayment o --- principal and interest but also --- or technical noncompliance, may require the entrepreneur to dedicate substantial e --- --- orts to servicing the loan. It is critical to read care --- ully and --- ully understand any loan agreement be --- ore signing. I --- the terms o --- the loan are so troublesome that they will prevent the business --- rom running properly, it may be best to look --- or another source o --- --- inancing. 3 Equity --- inancing 3.1 Introduction Equity is a share o --- a business. In --- act, equity in corporations is actually called shares or shares o --- stock. An entrepreneur who raises money through equity --- inancing e --- --- ectively sells pieces o --- the company in return --- or outside investment. The outside investors thereby become inside shareholders, who have certain legal rights and privileges that lenders do not enjoy. Pro --- essional equity investors include angels and venture capitalists (Oranburg, 2015a). Angels --- orm groups that collectively invest an average o --- $350,000 o --- their own money in a very early- stage start-up, while venture capitalists --- orm --- unds that invest an average o --- about $7.3 million in a more mature company (Oranburg, 2015a). These independent venture capital (IVC) investors (which may also include private corporations that have venture --- unds) contribute the vast majority o --- start-up capital in America and the world, but some countries have established government venture capital (GVC) --- unds and mixed public-private partnership --- unds. Public investors provide capital to entrepreneurs that IVC investors may not because GVCs are under political pressure to pursue domestic employment and other non --- inancial goals (Cumming et al., 2014). 3.2 Pros and cons The overwhelming advantage o --- equity --- inancing --- or start-ups is that there is no loan that must be paid back. With equity --- inancing, there is no risk o --- bankruptcy as a result o --- --- ailing to repay investors. This gives start-ups the --- lexibility to deploy invested capital in growing the business. Investors do not expect to be repaid until the business becomes pro --- itable, and even then, equity investors may be willing to reinvest the pro --- its to continue growing the business, especially --- or social reasons (Terziev, 2017). The reason equity investors are so --- lexible about being repaid is that equity owners are entitled to a share o --- the total value o --- the start-up. The investor joins the entrepreneur in sharing business risks by providing risk-bearing capital (Weijs, 2018), and both have similar incentives to grow the business as large as possible be --- ore cashing out (Huang, 2017). This creates a partnership dynamic between the entrepreneur and the equity investor, which may be welcome in some situations, but also one that can create --- rustrations --- or the entrepreneur. As a co-owner in the business, the equity investor is entitled to vote on --- undamental transactions, such as a merger or a sale o --- substantially all the company's assets. Once equity investors 6 Electronic copy available at: https://ssrn.com/abstract=2743072 purchase stock in a start-up, the entrepreneur may lose control over when to liquidate the business and exit the market. In --- act, many equity investors will push --- or an exit within eight to ten years o --- their initial investment. While the entrepreneur --- requently gets paid to operate the business, the equity investors typically gets a return on their investment only when it liquidates. Some equity investment contracts even contain a provision where the investors can --- orce the company to go public (Smith, 2005). Another con about equity --- inancing is that the investors typically receive pre --- erred stock, whereas the --- ounders and employees typically receive common stock. Pre --- erred stock is so named because it has certain pre --- erences, including the right to be paid --- irst in a merger or liquidation, the right to receive dividends, and the right to block certain transactions such as another debt or equity --- inancing. Founders need to realize that equity --- inancing not only gives up a share o --- their business to investors, but it also subordinates --- ounders' equity position to investors. The common stockholders usually have --- inancial rights only in the residual, which is the amount that remains a --- ter the pre --- erred stockholders are --- ully paid --- or their initial investment, dividends they have accumulated, and any liquidation pre --- erence they are owed. Pre --- erred stockholders may even have the right to participate, which means that a --- ter they receive their pre --- erence, the pre --- erred stock converts to common and receives a percentage o --- the residual as well (Walther, 2014, p. 167). Pre --- erred stockholders lack the a --- --- irmative covenants o --- ten --- ound in bank loans, but they need a way to make sure that management is acting in the investors' best interests, so they o --- ten bargain --- or management rights or even a seat on the company's board. Giving an investor one seat out o --- three may not seem like a big deal at --- irst but remember that start-ups o --- ten raise multiple rounds o --- outside investment. Each --- undraising round may result in giving up another board seat, so that by the third round the equity investors may outnumber the --- ounders on the board by three to two. At this point, the investors can --- ire the CEO and replace management. Only the strongest start-up --- ounders are able to raise multiple rounds o --- equity --- inancing without eventually giving up a majority o --- board seats to investors. Most --- ounders who raise equity --- inancing should expect to be at the mercy o --- outside investors at some point in their start-up's li --- e cycle (Wasserman, 2012). But --- ounders are o --- ten overly worried about maintaining control. Equity investors are in the business o --- selecting and overseeing start-ups in which to invest, not in the business o --- running them. A good CEO will --- ind his position secure, and quite --- rankly it may be in everyone's best interest to replace an underper --- orming CEO with someone who can really build the business. The original --- ounding team should be vested in most or all o --- their common stock (meaning they have the right to keep that stock even i --- they are --- ired) by the time equity investors control the board, so they can actually pro --- it --- inancially --- rom such a change o --- control (Empey, n.d.). Sometimes the --- ounding CEO is a visionary who can build something new, but not an 7 Electronic copy available at: https://ssrn.com/abstract=2743072 administrator who can run a large and success --- ul organization. This can be hard --- or a CEO to admit, but success --- ul repeat entrepreneurs learn their own strengths and weaknesses. The close and interdependent relationships between entrepreneurs and investors that arise --- rom equity --- inancing agreements are not --- or every start-up --- ounder. Those --- ounders who demand complete control may be --- rustrated when each --- inancing round slowly drains power --- rom their grasp. But --- ounders who are open-minded about the business model and their role in the company may actually --- ind that equity investors have valuable experience, connections, and skills that can be employed to dramatically improve the business. The key thing to remember when sorting out the pros and cons o --- equity --- inancing is this: equity investors are more than money. Equity investors are partners. Some analogize the --- ounder/investor relationship to a marriage. Choose someone you trust and want to work with --- or many years. 3.3 Key issues The biggest issue with equity --- inancing is that it may not be available during certain stages o --- start-up development. There are currently two main types o --- equity --- inancing investors, angels and venture capitalists. Angels typically --- und less than $1,000,000 and venture capitalists typically --- und more than $5,000,000, so start-ups trying to raise about $3,000,000 o --- ten have trouble attracting investors (Oranburg, 2016). Moreover, these investors pre --- er business models that can scale quickly, which is why they o --- ten invest in so --- tware start-ups. Start-ups that make physical goods or that require a large input o --- human capital may --- ind it di --- --- icult to attract equity investors. Fortunately, there are more resources than ever to --- ind angels and venture capitalists who are in speci --- ic sectors. Web sites like Angel List connect start-ups to equity investors, incubators and accelerators have “demo day” to highlight emerging companies, and many large corporations have established venture --- inancing groups to help grow start-ups in their sector (Incubator, n.d.). Start-ups should plan their business model around the realities o --- equity --- inancing by planning to seek --- inancing at points in the start-up's li --- e cycle where investment will be at the highest levels. Another issue is that raising money through equity --- inancing requires a public disclosure o --- the securities issuance. There are web sites like Crunch Base, whose business is to look --- or --- ilings about such securities issuances and to post that in --- ormation online (www.crunchbase.com). There --- ore, one key issue with equity --- inancing is that it e --- --- ectively takes the start-up out o --- stealth mode and subjects it to public scrutiny. The solution to this issue is to treat the equity --- inancing like a PR campaign and use the press to the company's advantage through e --- --- ective communication and good timing. Once a start-up raises money through equity --- inancing, the company e --- --- ectively has a value as o --- a certain point in time. The value is determined simply by dividing the amount o --- money invested in the start-up by the percentage o --- equity received --- rom that investment (e.g., i --- investors pay $1,000,000 --- or 10%, the start-up has a value o --- $10,000,000). This has many 8 Electronic copy available at: https://ssrn.com/abstract=2743072 implications. For example, start-ups o --- ten incentivize employees to work long hours --- or less pay by o --- --- ering stock options. The value o --- a stock option is the di --- --- erence between the price that the employee must pay to get the stock (this strike price is set by contract and does not change) and the value o --- the stock (the market price, which changes --- requently). Clearly, the employees pre --- er to get stock options when the strike price is low, but there are laws about setting the strike price based on the value o --- the company. Once the company has a value determined by outside investment, the strike price typically increases dramatically, making stock options less valuable. There --- ore, it may be a good idea to grant stock options be --- ore seeking an equity investor (Casserly, 2013). Another issue is the expense o --- doing an equity --- inancing. Expect legal --- ees to cost at least $25,000 --- or a standard equity --- inancing. That cost can increase dramatically i --- the start-up has done a poor job o --- maintaining records and complying with corporate --- ormalities be --- ore the --- inancing. The equity investors will require the start-up to pay lawyers to clean up the books and records be --- ore closing the investment. This process can also require the entrepreneurs to spend a lot o --- time on due diligence, the process by which the start-up discloses in --- ormation to the investor who then reviews the business. During this process, some issues like lawsuits, patent in --- ringement, and disgruntled employees may come out and be memorialized inde --- initely in the stock purchase agreement. Start-ups that have the --- inancial means to do so would be well advised to ensure their corporation is compliant with the law be --- ore seeking --- inancing (Gartner et al., 2012). Finally, the stock purchase agreement and other equity --- inancing documents are technical and complicated, but in a di --- --- erent and more dangerous way than bank --- inancing documents. Whereas debt- --- inancing documents can contain numerous restrictive covenants and severe penalties --- or late payment, a --- ounder can easily recognize the important economic terms such as interest rate and loan term. In equity --- inancing, however, the economic terms are much more complex. For example, simply changing the liquidating pre --- erence multiple --- rom one to two means that, in the event o --- an acquisition or liquidation, the pre --- erred stockholders get twice their investment be --- ore the common stockholders get anything. A sophisticated entrepreneur can learn about these terms by studying a term sheet and reviewing the annotated version o --- these --- orms (available online at nvca.org), but a good lawyer is truly worth hiring in this context, where a seemingly tiny detail can result in millions o --- dollars. 4 Convertible debt --- inancing 4.1 Introduction Convertible debt is a hybrid between debt and equity. Convertible debt is technically a loan, typically with a very low or nominal interest rate. The interest rate can be low because the point o --- the loan is not to earn money on interest but to convert the debt to equity upon a triggering event, such as another --- inancing or the expiration o --- a period o --- time. Convertible debt was 9 Electronic copy available at: https://ssrn.com/abstract=2743072 traditionally used --- or bridge loans, which are loans between two rounds o --- --- inancing to carry the start-up through a brie --- but tough time. Nowadays, start-ups --- requently receive their --- irst --- inancing (also called seed --- inancing) through convertible debt because this seed note method is relatively quick, cheap, does not require the company to be --- irmly valued, and may not require the start-up to make the public disclosures associated with stock issuances (Werner, n.d.). 4.2 Pros and cons The main advantage o --- convertible debt is that this method is quick and inexpensive. Whereas an equity- --- inancing round can easily cost $25,000 or more, a seed note round can be accomplished --- or $5000 or less. The reason --- or the low cost is that seed notes are very simple instruments that e --- --- ectively put o --- --- discussions regarding valuation, board seats, protective provisions, liquidation pre --- erences, and many other complex terms until a triggering date or event in the --- uture (Werner, n.d.). Until the seed note converts to equity, the noteholder is not a stockholder. Noteholders are not entitled to shareholder rights such as voting on mergers, and they almost never receive protective provisions. Seed notes also generally lack the strict a --- --- irmative covenants --- ound in conventional debt agreements. As a result, entrepreneurs are generally --- ree --- rom virtually any investor in --- luence during the pre-conversion period (Kramer and Levine, 2012). Seed notes also do not require the entrepreneur and the investor to agree on a valuation o --- the company. The notes do not translate into a percentage o --- equity until the next equity --- inancing. This eliminates what is o --- ten the most contentious aspect o --- start-up --- inancing: valuing a new and unique company in its very early stages. The --- lip side o --- this kick-the-can-down-the-road method is there is a great amount o --- uncertainly as to what investors will ultimately receive. To understand why requires a brie --- discussion o --- how seed notes work. There are essentially only --- our material terms in a seed note agreement. First, how much will be invested as debt? Second, at what interest rate should the debt accrue? Third, when does the debt investment convert into equity? Fourth, does the debt investor get a discount (relative to later investors) when the note converts at the next --- inancing? There are some other material terms such as what happens in the event o --- a pre-conversion acquisition and whether the investor shall receive --- inancial statements during the pre-conversion period, but the --- ocus is generally on the economics o --- conversion in the next --- inancing (Werner, n.d.). The seed notes will likely stipulate that the noteholder gets equal or better rights than any new investor in the next equity --- inancing, and the noteholder will pay the same or less than any new investor in that next round (Werner, n.d.). However, when the note is --- ormed, neither party has any way to know what the rights nor price o --- the next --- inancing will be. There are a --- ew techniques employed to address this uncertainty, such as a valuation cap, which re --- lects the highest price per share that the noteholder will pay upon conversion, but the uncertainty 10 Electronic copy available at: https://ssrn.com/abstract=2743072 regarding --- inal terms about control, pre --- erence, and voting rights is the unavoidable consequence o --- not negotiating these terms up --- ront. 4.3 Key issues Negotiations over seed notes typically --- ocus on two main economic terms, the cap and the discount. First, consider a situation where there is no cap and no discount. The start-up issues 1,000,000 shares o --- common stock to --- ounders. Then a seed note investor purchases a $100,000 note with 0% interest. Later, an equity investor values the 1,000,000 shares at $1,000,000 (this is called the pre-money valuation), or $1.00 per share, and agrees to purchase 200,000 shares o --- pre --- erred stock --- or $200,000. Upon the closing o --- that stock purchase, the seed note investor receives 100,000 shares o --- pre --- erred stock, too. A --- ter the equity --- inancing, the --- ounders hold 77% o --- the equity (Werner, n.d.). Now take these same --- acts, except that the note has a 20% discount. That means the noteholder pays $0.80 per share and receives 125,000 shares o --- pre --- erred stock. A --- ter the equity --- inancing, the --- ounders hold only 75% o --- the equity. Instead o --- a discount, assume the note has a $500,000 valuation cap. That means that the noteholder will never pay more than $0.50 per share (which is derived --- rom a $500,000 valuation --- or 1,000,000 shares). Now the noteholder receives 200,000 shares o --- pre --- erred stock, and a --- ter the equity --- inancing, the --- ounders hold only 71% o --- the equity. Finally, consider a note that has a $500,000 cap and a 20% discount. Typically, a noteholder gets the better o --- the two options, but not both. Under the previous --- acts, the cap is more valuable than the discount. However, i --- the new equity investor valued the company at less than $625,000, the discount would instead be applied because it is more valuable to the noteholder. As this hypothetical situation should make clear, the number o --- shares that a seed note investor ultimately receives cannot be determined when the note is issued. Rather, the noteholder receives a number o --- shares that is dependent on the valuation by the next equity investor. This can create a con --- lict o --- interest between the noteholder and the --- ounder. The holder o --- a note that does not have a cap may want the company to close its next equity --- inancing when the stock value is as low as possible as to get the highest number o --- shares, whereas the company is best served by holding out --- or a higher valuation. On the other hand, i --- the note is capped, both the note holder and the --- ounders may want to receive a high valuation in the next round, but i --- the valuation is too high, then the note holder will e --- --- ectively get a massive discount vis-à-vis the next equity investor. This can seem un --- air and thus discourage an equity investor --- rom investing in the start- up. Another issue with seed-note --- inancing is that the noteholders eventually become equity holders, so many o --- the same issues discussed earlier apply here. Founders should consider how such investors will act as stockholders be --- ore accepting their investment. In the early stages o --- a 11 Electronic copy available at: https://ssrn.com/abstract=2743072 closely held corporation, stockholders can in --- luence management and prevent certain corporate actions. An investor who contributes $100,000 in a seed note round may need to consent to a sale o --- the company --- or $10,000,000 several years later. Be --- ore accepting --- unds, remember that equity investment is a long-term relationship, and that seed noteholders will become equity holders. 5 Crowd --- unding 5.1 Introduction Crowd --- unding is “the use o --- small amounts o --- capital --- rom a large number o --- individuals to --- inance a new business venture.” (Smith, 2019). This is typically accomplished utilizing the internet and various social media plat --- orms, allowing the general public to take part in the investing process (Prive, 2012). This “approach is attractive to entrepreneurs, because it not only allows raising capital --- or small businesses, which have very limited --- inancing options, but also serves as a tool --- or testing marketability.” (Valanciene & Jegeleviciute, 2013). Others have described this “market test” --- unction as the non-pecuniary value o --- crowd --- unding. (Oranburg 2015b). New laws allowing crowd --- unding have been promoted by the Obama administration because “crowd --- unding o --- --- ers real promise --- or underserved business entrepreneurs and may allow the organizations that serve them the ability to reach even deeper into the entrepreneurial community” (Rand, 2012). There are high hopes --- or this new --- undraising model. Business scholars have even suggested that crowd --- unding can change the very nature o --- capitalism by dramatically lowering the di --- --- iculty o --- raising --- unds (Macaulay, 2015) by bringing about “more e --- --- iciency, lower transaction costs and increased --- lexibility in world --- inancial markets.” (Fanea- Ivanovici, 2019). But crowd --- unding is not entirely new. Crowd --- unding is a blanket term that covers a range o --- di --- --- erent models --- or raising capital, which can be categorized into --- ive types: (1) donations, (2) rewards, (3) pre-purchases, (4) lending, and (5) equity crowd --- unding. Entrepreneurs can combine these models --- or speci --- ic --- undraising purposes. 5.1.1 Donations The donation model o --- crowd --- unding does not involve the sale o --- securities (Sheik, 2013). Those who donate to crowd --- unding projects do not receive any --- inancial interest or material return on their investment. (Zhao, 2019). This appeals to donors who want to --- oster the development o --- intangible common goods and social wel --- are projects. Donors --- or these projects do not receive a direct, private bene --- it, although they may appreciate an indirect, public bene --- it to donors and nondonors alike. This altruistic donation model o --- crowd --- unding has proven popular --- or charities due to its transparency and personal touch (National Overview, n.d.), but it is not a common way that --- or-pro --- it start-ups raise money (Belle --- lamme et al., 2011). It is more common --- or 12 Electronic copy available at: https://ssrn.com/abstract=2743072 entrepreneurs to seek --- inancing with an approach that eschews the donation model or combines it with one or more o --- the other models described next (Belle --- lamme et al., 2011). 5.1.2 Rewards The rewards model o --- crowd --- unding allows a supporter to invest in an organization or cause in return --- or a reward such as being “credited in a movie, having creative input into a product under development, or being given an opportunity to meet the creators o --- a project.” (Bi, 2017). The reward model is o --- ten combined with the donation model. For example, due to --- inancing problems during the construction o --- the Statute o --- Liberty in 1884, Joseph Pulitzer urged the American public in his newspaper New York World to donate money --- or the statue’s pedestal. In response, approximately 125,000 people donated over $100,000 to the project. As a reward, Pulitzer published the names o --- each individual who contributed to the project in his newspaper. (National Parks Service, 2019). More recently, large donors to The Canyons movie received cameos, script reviews, and even the money clip that Robert DeNiro gave director Burt Schrader on the set o --- the movie Taxi Driver as a reward --- or their contributions to the --- ilm. (Rodrick, 2013). Kickstarter is a crowd --- unding website that encourages the use o --- the rewards model (Rewards, n.d.). Rewards include copies o --- the thing produced, limited editions o --- the product, collaborations with the donor in the production, experiences with the producers, and mementos o --- the project (Rewards, n.d.). Being rewarded with the --- inal product is similar to engaging in the pre-purchase model o --- crowd --- unding described later, but the distinction is that rewards are technically considered gi --- ts that are not o --- --- ered --- or sale (Terms o --- Use, n.d.). Start-ups that produce consumer goods --- ind that the rewards model is an e --- --- ective way to raise capital, although more money can be raised more easily with the pre-purchase model described next. Start-ups that cannot easily produce an entertaining reward have trouble using the rewards model o --- crowd --- unding. 5.1.3 Pre-purchase The pre-purchase model is the most common type o --- crowd --- unding (Brad --- ord, 2012). Under the pre-purchase model, the consumer pays in advance --- or the product. I --- the start-up launches the product, the consumer typically receives that product --- or a lower price than regular customers who purchase the product a --- ter it is already on the market (Hossain, 2015), and the consumer receives nothing i --- the start-up --- ails (Manderson, 2012). For example, i --- you pledged $185 or more on Kickstarter in 2014 --- or the Coolest Cooler™, that start-up promised to send you the cooler with some add-ons and “swag” by February 2015. (Kickstarter, 2019). This was a special price --- or early investors. Today, the Coolest Cooler™ has a starting retail price o --- $249.99. (Coolest, 2019). However, the $13 million they initially raised was not enough to get the product out to investors. “[M]ore than 60,000 backers were supposed to receive their coolers in February 13 Electronic copy available at: https://ssrn.com/abstract=2743072 2015. Many did, but many more did not as delays and glitches hit production,” requiring the company to raise additional --- unds. (Feldman, 2016). 5.1.4 Lending Banking is a heavily regulated industry, and much o --- crowd-lending is regulated by --- ederal agencies. As a result, there tend to be --- ewer plat --- orms --- or crowd-lending. The crowd-lending plat --- orm Lending Club was the such plat --- orm to register with the Securities and Exchange Commission (FAQ --- or New Investors, n.d.). Lending Club’s --- inancial innovation is to connect lenders and borrowers in what is called peer-to-peer (P2P) lending (Verstein, 2011). On Lending Club, customers interested in a loan complete a web-based application that is evaluated by Lending Club --- or creditworthiness and assigned an interest rate (FAQ --- or New Investors, n.d.). Investors select loans in which to invest based on risk --- actors and interest rates (FAQ --- or New Investors, n.d.). The minimum required to invest is only $25, so broad diversi --- ication is possible --- or Lending Club investors with limited capital (Earn Solid Returns, n.d.). The term o --- loans on Lending Club are generally 3 or 5 years, at a --- ixed interest rate and straight-line amortization (Lending Club, 2014). The lending model works best --- or start-ups that deal with tangible goods and have some sort o --- collateral. The risk o --- nonrepayment --- or unsecured business loans is very high, so investors require a commensurately high return on investment to compensate --- or this risk. To receive such a high rate o --- return through the lending model o --- crowd --- unding, interest rates on the loans may be so high as to be illegally usurious. By posting collateral, producing valuable goods, or holding real property, start-ups can reduce their risk o --- nonpayment and obtain “crowdlending” on more --- avorable terms. 5.1.5 Equity crowd --- unding The Jumpstart Our Business Start-ups Act o --- 2012 (the JOBS Act) amends Section 4(a)(6) o --- the Securities Act o --- 1933, as amended (15 U.S.C. § 77d(a)(6) (2015)) (the Securities Act), to allow a private corporation to o --- --- er and sell up to $1 million worth o --- equity securities (stock) in a 12- month period to the general public without registering the securities with the SEC. This new exemption to registration under the Securities Act is generally called crowd --- unding, although this --- ederal law is more accurately called equity crowd --- unding. (Securities and Exchange Commission (SEC), 2012). There are also o --- dozens o --- intrastate equity crowd --- unding laws that are available where companies and investors are located in the same state, but these varied and nascent laws are beyond the scope o --- this chapter. The SEC issued its --- inal rules on equity crowd --- unding on October 30, 2015, and went into e --- --- ect to allow Internet --- unding portal registration on January 29, 2016 and to allow stock issuance starting on May 16, 2016 (SEC, 2015). The size o --- this --- inancing market, the role o --- the --- unding portals, and many other details will take time to emerge. However, some o --- the key crowd --- unding rules are provided in the JOBS Act itsel --- . Individuals who have between $100,000 14 Electronic copy available at: https://ssrn.com/abstract=2743072 and $1 million in annual income or net worth may invest 10% o --- it each year in start-ups through crowd --- unding (15 U.S.C. § 77d(a)(6)(B)(ii) (2015)). Individuals who have or annually earn less than $100,000 may invest the greater o --- $2000 or 5% o --- their annual income each year in start- ups (15 U.S.C. § 77d(a)(6)(B)(ii) (2015)). 5.1.6 Venture Philanthropy At its core, venture philanthropy is modeled around the same concepts as venture capital. Venture capitalists aim to quickly grow start-ups by providing large amounts o --- --- unding in the hopes o --- earning a high rate o --- return o --- --- o --- their investment (Davila, 2003). Venture philanthropists have the same aim as venture capitalists but, instead o --- trying to grow their wallets, venture philanthropists “invest” in the hopes o --- increasing net social wel --- are --- or society (De --- ourny, 2016). They aim “to serve more people, more e --- --- ectively.” (Grossman, 2013). Philanthropic investors concentrate their support on creating new and innovative answers to current social issues they are interested in like medical research, environmental clean-up e --- --- orts, or education re --- orm (Zeichner, 2017). That is, investors are not, at least initially, concerned with turning a pro --- it; their investment is intended mostly (or entirely) --- or philanthropic purposes. The Bill and Melinda Gates Foundation, --- or instance, provide --- unds worldwide --- or a variety o --- social issues (Gates, n.d.). Venture philanthropy has characteristics similar to the various --- unding methods discussed above. Generally, this --- orm o --- --- unding tends to act similarly to the donation model in that the investor gives a large sum o --- capital to the start-up but does not receive any --- inancial interest or material return on their investment. Their “return on investment” is simply the bene --- it provided to society i --- the venture succeeds. However, this does not mean a monetary return is out o --- the question. Some reports have highlighted the importance o --- venture philanthropy and its e --- --- ect on impact investing (Bannick, 2012). Impact investing is a combination o --- venture philanthropy and venture capital in that it serves the dual purpose o --- earning --- inancial returns while addressing a speci --- ic social issue (Barber, 2017). Impact investing can then mimic the lending model --- or start- up --- inancing and allow the philanthropist to trans --- orm into the capitalist once the philanthropic endeavor has scaled accordingly. Start-ups whose value proposition includes a clear social bene --- it – such as providing clean water in rural areas, reducing environmental hazards in cities, connecting --- irst responders with emergency situations, o --- --- ering crisis counseling through chatbots and AI, optimizing --- ood waste collection, and perhaps even o --- --- ering mobility solutions like a network o --- scooters – may have access to capital --- rom venture philanthropists and impact investors. For such mission-driven start-ups, venture philanthropists and impact investors o --- --- er --- inancing on very company- --- avorable terms. Start-ups should note that while some venture philanthropists give generally, many have a particular --- ocus on a sector or industry, or an even narrower --- ocus on solving a speci --- ic problem. This is even more true with impact investors, who generally specialize in a particular industry or impact area. Accordingly, mission-driven start-ups should research which 15 Electronic copy available at: https://ssrn.com/abstract=2743072 venture philanthropists and impact investors may be interested in their region, industry, or solution. 5.1.7 Initial Coin O --- --- erings Initial coin o --- --- erings (ICOs) are the newest --- orm o --- start-up --- inancing available today. These o --- --- erings raise --- unds by selling crypto-tokens or “coins” in exchange --- or legal tender or other cryptocurrencies through a blockchain (Amsden, 2018), similar to selling stock in an initial public o --- --- ering (“IPO”). IPOs, however, are heavily regulated by the SEC, whereas ICOs remain mostly unregulated. In a typical ICO, the “coins” that are initially sold will later serve as the medium o --- exchange on a peer-to-peer plat --- orm (Li, 2018). Blockchain start-ups have embraced ICOs as a vehicle to raise early capital. (SEC, 2018). The “coins” o --- --- ered in these sales are intended to --- ill a widely varied set o --- roles on di --- --- erent plat --- orms. Some “coins” are similar to currencies, others act more like securities in a publicly traded company, and others have properties that are entirely new (Conley, 2017). Such a new medium o --- exchange is not without risk: ICO advisory --- irm Statis Group recently published a study claiming more than eighty percent o --- ICOs conducted in 2017 were scams (Alexandre, 2019). Cryptocurrency start-up Con --- ido, --- or example, raised $375,000 through one such ICO be --- ore vanishing with investors’ money (Kharpal, 2017). Instances similar to Con --- ido are numerous, so it is recommended that entrepreneurs avoid ICOs --- or their --- inancing needs. Presently, due to the absence o --- regulation, ICOs are too risky to properly employ --- or sustainable start-up --- inancing. 5.2 Pros and cons Whether or not crowd --- unding is right --- or your start-up may depend on your mission or on the nature o --- the product your business will produce. Crowd --- unding, especially donation and rewards crowd --- unding, can be very use --- ul --- or start-ups with a primary purpose o --- producing a social bene --- it because crowds may be inspired to --- und projects that create a public good. The rewards model o --- crowd --- unding, in particular, has been used by nonpro --- it organizations like the Smithsonian Institute to --- und public-work projects like the Reboot the Suit campaign (Reboot the Suit, n.d.). This may extend to eco- --- riendly projects and socially responsible investing (Chamberlain, 2013). Consumer products are the basis o --- the most success --- ul crowd --- unding campaigns on leading plat --- orms like Kickstarter and Indiegogo. Only one o --- the top 15 crowd --- unding campaigns in 2014 was not --- or a consumer product, although it was --- or Reading Rainbow, a social bene --- it project (15 most --- unded, 2015). Business-to-business (B2B) crowd --- unding has not taken o --- --- with a donation, reward, or pre- purchase model. B2B companies and service companies are probably limited to the lending and equity crowd --- unding models unless their business --- ocuses primarily on providing a compelling 16 Electronic copy available at: https://ssrn.com/abstract=2743072 social bene --- it. There --- ore, start-ups o --- --- ering B2B solutions will probably not seriously consider crowd --- unding as the primary means to --- inance the business; however, as equity (investment) crowd --- unding develops, it could become a use --- ul --- inancing tool --- or B2B start-ups. A bene --- it o --- non-equity crowd --- unding is that entrepreneurs maintain control o --- the business. Backers obtain no control rights under the donation, reward, or pre-purchase model, although start-ups that raise money in these ways may --- eel obligated to keep backers in --- ormed about progress. That is not to say, however, that there are no rules regarding non-equity crowd --- unding. To the contrary, the Federal Trade Commission has sued start-ups that sought money on Kickstarter and --- ailed to deliver products (Federal Trade Commission (FTC), 2015). There --- ore, non-equity crowd --- unding creates legal risks --- or entrepreneurs and companies. Under lending crowd --- unding models, the lender may obtain some contractual rights to the start-up's books and records, and the start-up may be --- orbidden --- rom selling more equity or taking on more debt while the crowd --- unded loan is outstanding. The restrictive covenants on crowd --- unded loans vary widely depending on the plat --- orm, loan amount, and other --- actors. Raising money through equity crowd --- unding requires making a number o --- disclosures. Start-ups must --- ile a Form C with the SEC, keep various records, and produce --- inancial statements be --- ore raising more than $500,000 (Lingam, n.d.; Crowd --- unding, 2013). I --- a start-up raises a substantial amount o --- money through equity crowd --- unding, it may have to get stockholder approval --- rom the crowd --- unding investors, which may be a diverse and hard-to-contact group. That can slow down or even prevent management --- rom engaging in corporate --- inance and acquisition activities. 5.3 Key issues The donation, reward, and pre-purchase crowd --- unding models do not involve the sale o --- any securities under --- ederal law (Brad --- ord, 2012). The touchstone o --- the Supreme Court's test --- or what de --- ines a security is whether the investment is premised on a reasonable expectation o --- pro --- its (United Housing Foundation, 1975). But start-up investors are generally not interested predominately in non --- inancial rewards. Investors generally want to earn a return on their investment, so donations, pre-purchases, and non --- inancial rewards can only attract a limited number o --- investors (Brad --- ord, 2012). To o --- --- er investors an opportunity to earn business pro --- its, entrepreneurs will have to comply with securities regulations including Title III o --- the JOBS Act o --- 2012. As discussed earlier, the biggest issue with donation, rewards, and pre-purchase crowd --- unding is that there are very --- ew examples o --- B2B or service companies using those models success --- ully. That means lending and equity crowd --- unding may be the only crowd --- unding options --- or many start-up. Crowdlending has many pros and cons, as discussed earlier, but it may be easier --- or a start-up to get a loan through crowd --- unding than through a conventional bank. 17 Electronic copy available at: https://ssrn.com/abstract=2743072 The biggest issue with equity crowd --- unding that it is new, so investors are skeptical and unsure how it will work. This limits investor interest in this --- undraising modality. Congress is working on JOBS Act 2.0, so there is additional regulatory uncertainty around equity crowd --- unding because Congress may change the statute that enables it (Cli --- --- ord, 2015). I --- companies use crowd --- unding to commit --- raud, that may cause a backlash against equity crowd --- unding that potentially shuts down the entire model (Hazen, 2012). At this stage in the development o --- equity crowd --- unding, there are many political, legal, business, and societal uncertainties that make this new model both exciting and risky. 6 Conclusions and --- uture trends The --- inancial --- uture looks bright --- or many high-growth start-ups. Thanks in part to social media and Web 2.0 technology, new approaches to start-up --- inancing are rapidly emerging. Equity (investment) crowd --- unding is now permissible in the United States, and over two dozen equity crowd --- unding web sites have registered as --- unding portals. Crowdlending web sites like Lending Club and Prosper continue to increase access to debt --- inancing without banks. Angel investors are sourcing deals online through angel crowd --- unding portals such as Angel.co and OurCrowd.com, which led to angel investments in 66,110 di --- --- erent companies in 2018. Meanwhile, venture capitalists pumped $131 billion into start-ups in 2018 – eclipsing the $100 billion watermark previously set at the height o --- the dot-com boom in 2000. Hundreds o --- billion- dollar start-ups – once called “Unicorns” --- or their rarity – are now common household names. Yet there are several mars on this otherwise rosy picture. Minority, --- emale, and rural businesspeople still do not receive venture capital at the same rates as white, male entrepreneurs in big cities such as San Francisco and New York. Crypto-currencies turned out to be --- raught with scams and other perils. And some companies – notably slow-growth small businesses in more traditional industries – have seen relative or absolute diminutions in their --- inancing prospects. However, scholars and policymakers are now --- ocusing on --- inding solutions to these problems, and venture philanthropists and impact investors are actively seeking opportunities to make investments in diversity and inclusion. With all the options that abound in start-up --- inancing today, it’s more important than ever to --- ormulate a business plan includes a --- inancing strategy. Working with a good start-up lawyer can help entrepreneurs understand the legal and business implications o --- --- inancing choices. 18 Electronic copy available at: https://ssrn.com/abstract=2743072 Re --- erences 15 Most-Funded Crowd --- unding Projects on Kickstarter and Indiegogo, February 16, 2015, Forbes, http://www. --- orbes.com/sites/gilpress/2015/02/16/15-most- --- unded-crowd --- unding- projects-on-kickstarter-and-indiegogo/4/. Alexandre, A. (2019, February 14). New Study Says 80 Percent o --- ICOs Conducted in 2017 Were Scams. 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