Occasionally we invite clients to discuss issues of importance to those who work with freelancers on Elance-oDesk. Here are some additional thoughts from Nicholas Wright. He frequently hires freelancers and is one of the founders of AppInstruct, an online course that teaches people how to make an app utilizing the Elance-oDesk platforms.
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Earlier posts in this series have looked at:
How to turn your idea for a new mobile app into an working app
Exploring the concept of minimum viable product
Tips on how the start-up fundraising process works
Equity and control options
This week we’ll run through the two main methods of fundraising for your startup—shares (equity) and convertible notes (debt). We’ll also discuss the advantages and disadvantages of each method.
Shares and equity
Equity (or shares in the company) is the most common method of raising investment for a startup. It’s also likely to be a concept you are familiar with. In exchange for investing a certain amount of money, investors are issued a set number of shares at a certain value per share—such as $1 per share.
The principal problem faced by founders and investors alike with this approach is agreeing what the company is worth—especially since the startup is yet to launch its product, much less earn any revenue. This valuation is critical, as it determines how large a piece of the company everyone (founders and investors alike) will own, once the investment is received and the shares issued. 
By way of a simple example, if the company raises $500,000 (a standard-sized pre-launch investment ‘seed’ round) at a pre-money valuation of $2 million, after the investment your investors will own 20% and the founders 80% (the seed money is added to the valuation, meaning a post-money company valuation of $2.5 million).
If the company raises $500,000 at a pre-money valuation of $4.5 million, then those same investors will only own 10% of the company post-money. Hence, they would own half the portion of the company at the lower valuation.
This means that there may be a need for a significant amount of negotiation between the founders and investors. This negotiation will consume valuable time from the founders—energy that could otherwise be focused on getting the company’s product perfected.
The other factor with equity is that upon issuing it, there will normally be significant negotiation as to who has control over the company and its decision making. While there are accepted parameters around these negotiations, the need for them often means that an equity investment might take 6-8 weeks to finalize once the investors commit to investing by signing a term sheet. In most cases, during that time period there remains a risk to the company and the founders that the investment will not be finalized and the funds not released.
Convertible notes—debt
Convertible notes differ from equity in that they are a debt instrument. That is, they don’t immediately confer on the investor a share in the company. Instead, they provide the investor with a right for the note to be converted into equity (upon the occurrence of a pre-determined event—normally the company raising a certain amount of funding by way of a share issue). Essentially, they provide a future right to a share in the company, but not immediate ownership of that share.
Notes became popular in certain investment markets, such as California and the United Kingdom, a couple of years ago. This is because they were perceived to offer certain benefits over raising funds by way of equity pre-launch. Keep in mind that convertible notes do not necessarily need to include a valuation. If the founders and investors both agree, determining the valuation can be postponed until the first round of qualifying equity funding is raised.
This is reasonable for all, as this qualifying round will occur after the product has launched. Because of this, there will exist some real data as to the company’s prospects on which to base the valuation.
In reality, however, investors will argue that they deserve more potential upside than simply investing later. This is because early-stage investments are by far the riskiest to make. Investors will therefore seek to insert a valuation cap in the note (for example $5 million), at which time their notes are guaranteed to convert. This is regardless of whatever the valuation achieves in the next round. Additionally, investors will also be given a potential discount in the next round if it’s conducted below that valuation cap. For example, if they have a 20% discount, their shares will be issued at $0.80 if the other shares are being issued at $1.00.
Over time, valuation caps have become an issue for founding teams. This is due to the fact that it can be very hard to raise your first equity round above them. Essentially, your new investors won’t like to see themselves receiving a worse deal than your seed investors.
The other main drawback with convertible notes, from the company perspective, is that they are unlikely to be as familiar to early-stage investors as shares. They also don’t bestow the same emotional sense of ownership on the investors as shares do. This means that they can be a harder sell in certain markets, and can hinder rather than assist the critical early fundraising process.
This being said, the other great advantage of notes is that they can easily allow a rolling close. It becomes far easier to bring in and close (receive fund transfer) from investors as you go than with equity, which requires more formality and is therefore normally conducted in smaller blocks.
If you’d like to learn more, we explore this topic in greater depth in Module 8 of AppInstruct’s course. In our next post, we’ll discuss non-disclosure agreements and look at when they are appropriate and when they’re not.