Starting a new venture is a large undertaking – after helping launch over 80 startups in the cannabis industry - we know. Not only should the founding team be researching, testing and building, but there also comes a point in some young companies’ lives where its time to start thinking about raising funds.
Not all companies need to fundraise, but after much introspection and evaluation, many young companies realize they can “do more faster” with more money in the company bank account. .
Figuring out if you need to fundraise is just the beginning. Entrepreneurs need to decide what type of funding is right for their business and stage of development. The good news is there are options… but that’s also the bad news. To make it easy, we’ve broken down some of the most common ways to drum up some extra capital early on.
This form of financing has become more popular with the proliferation of website and platforms that make crowdfunding simple and easy. There are four different types of crowdfunding:
Reward-based crowdfunding: In this type of crowdfunding, contributors donate small amounts of money ($1-1000+) in exchange for a product or service. Contributors are not required to be accredited investors, making it an easy way for startups to raise a small amount funds. But, it likely isn’t the best option to raise large funds due to the small contribution amount. As well, you put yourself at risk of potential legal action if you can’t keep your promise of delivering on whatever perk you exchanged for the cash, so be sure you can deliver. Popular sites include Republic, SeedInvest and Microventures,
Donation-based crowdfunding: Best suited for non-profits or causes, donation-based crowdfunding is exactly what it sounds like. Contributors give without an expectation of anything in return, making them ideal for causes and not so much for startups. You can try though. Popular sites are the same as for reward-based crowdfunding.
Equity-based crowdfunding: This is most relevant to startups and also one of the more confusing options. In this scenario, contributors give larger amounts ($1000+ usually) in exchange for equity and are sometimes not required to be accredited investors. There are a few different types, though:
- Regulation D equity crowdfunding - requires investors to be accredited but allows a startup to raise unlimited funds from an unlimited number of investors. However, this type requires offering to be done through a registered broker and usually prohibits startups from soliciting for contributions other than through word of mouth. Popular sites include CrowdEngine.
- Regulation A+ equity crowdfunding - this option is like a mini-IPO, allowing startups to raise a minimum of $3M up to $50M from unaccredited investors in exchange for some equity. It’s a great option with companies that already have a following, as it can energize customers to be invested (literally and figuratively) with the future of the business). However, there are fees associated with this type of raise, making smaller raises (under $6-10M) less appealing. As well, the time to clear investments can be 2-3 months so it’s not the timeliest option. SeedInvest is probably the most popular option of this type, though Regulation A+ does NOT require that the raise be done through a platform.
- Regulation CF equity crowdfunding - This is very similar to Regulation A+, except it requires the raise to be done through a platform like Republic, SeedInvest and Microventures and is limited to $1M. This makes it ideal for very early stage companies.
Debt-based crowdfunding: This form is very similar to equity-based crowdfunding except that the contributor is essentially providing a loan that will have to be paid back. These are often secured with some type of asset and usually require a bank custodian to support the process, making them less ideal for cannabis startups. When considering this, be sure that the loan is not a personal one, meaning that it would be backed by your personal assets (car, house, etc) because, if you default, you risk losing everything. Popular sites include Funding Circle and Zopa.
In terms of how crowdfunding works in the cannabis industry, there seem to be more cons than pros. The biggest issue with this type of funding for cannabis startups is that the crowdfunding site or platform stores the money collected on your behalf for a time. If that site or platform’s bank gets wind of the whole cannabis thing, you’re likely to get shut down and be left without any of those funds.
Debt is a well understood form of funding and is an option for small, early-stage companies that aren’t ready for the commitment and responsibility of equity funding. Loans can provide a source of cash to enable a start-up to get started (think: conducting research, acquiring early adopters, etc). However, in the cannabis industry, most loans are not going to come from the places your most familiar with. Instead, many of these loans will be from your FF&F - family, friends and fools - because not only do banks usually not provide loans to start-ups, but they are especially skeptical of businesses in the cannabis industry.
Consider the following when contemplating debt funding:
- Loans are traditionally backed by assets - whether that’s equipment, a lease or intellectual property. With software and technology companies, often the assets of the business are not significant - laptops, desks, chairs and servers. With state-licensed cannabis businesses, the assets might be very valuable - extraction units, lights, tables, expensive HVAC equipment. The more assets, the better the terms of the loan, so take serious stock of what you have to back your loan.
- Be very wary of any lender who asks for personal guarantees. These tie the loan to your personal assets - meaning that if you default, you could not only lose your business, but you could potentially lose your house, car, etc. No good.
- Debt obligations are paid out before investors which could make your business slightly less attractive if you plan to raise equity funding in the future. It’s certainly not a deal breaker, but something to keep in mind when choosing.
This is the most traditional form of financing that entrepreneurs choose and what investors like most because of its simplicity. We see it most often because it’s a great option for early-stage companies. In equity funding, the company sells shares to investors, providing the company with capital that doesn’t require it be paid back on a term or accrue interest, making it a clean and obvious choice for early-stage companies. However, it's important to remember that a company will likely have to give up a greater percentage of ownership to match risk with return in the early stages when the company has little value and, thus, can justify only a low valuation.
There are different equity funding options but the most common are Common and Preferred shares. These act very similarly with two key differences:
- Payouts: When there is plenty of money to go around, preferred shares are equivalent to common shares. However, when money is low, or a company calls it quits without enough cash to pay out all investors, preferred share owners are paid out before other shareholders, mitigating downside investment risk for them.
- Voting Rights: Many preferred shares will have slightly different voting rights, which can impact control of the company. This is often more important to investors than how money will be distributed because voting rights can allow those owners control and the ability to change things in the business -- including potentially how money flows.
There aren’t any specific rules on when you’d deploy one over the other; however, as you can imagine, preferred shares are generally preferred and are a safer investment than common shares for investors.
Convertible notes are a hybrid of debt/equity, as they are structured first as a loan which then converts into equity at a certain time or under certain triggers. Convertible notes are quite popular with startups in fast growing industries. They are attractive to investors because they avoid the sticky and tricky valuation conversation early in the life of a startup, replacing it with a valuation cap conversation. In addition, for investors convertible notes can offer investors a discount to the future valuation an incentive to invest early .
Some of the key points about convertible notes are:
- Term: How long until the note converts into equity; the average term we see is 18-24 months.
- Interest rate: This is pretty self-explanatory; the important thing to note is that an average interest rate on this type of debt is around 8%.
- Conversion triggers: Events that cause the debt to convert to equity shares. There are many different types of conversion triggers including time, a qualifying fundraising event, reaching certain predetermined milestones, at the election of the investor, at the election of the CEO, at the election of the Board of Directors, and more.
- Valuation cap: The maximum highest valuation at which the loan will convert into equity shares in the company. Investors will push for a lower valuation cap and entrepreneurs will advocate for higher valuation caps. Again, this gives the investor an incentive to invest into an early stage business.
A SAFE, or Simple Agreement for Future Equity, is quite similar to a convertible note but differs in one major way - it is not debt. Like convertible notes, SAFEs are an agreement for the future issuance of shares upon a specific event (valuation cap, sale of preferred shares, etc). However, unlike convertible notes, they are not a loan, but instead act more like a warrant or IOU.
There is no interest accrued on a typical SAFE and commonly there is no maturity date, keeping them from being subject to the same regulations as debt. That being said, unless specified, SAFE investments do not have priority in a liquidation, which can be negative for some investors.
Their simplicity and low costs have made them increasingly popular in the last few years, but mainly along the west coast where they originated.
Each funding option has its applications in the startup world. Depending on where your company is and what it’s goals are, one of these may be better than another. Just as a final breakdown, consult the chart below for an easy to analyze description of each of these options.