The Founder’s Guide to Structured Equity Financing in 2024

Structured equity financing is sort of like a custom financing toolkit for your startup's journey. Unlike a one-size-fits-all approach, this “toolkit” combines multiple financing instruments—convertible notes, preferred stock, and SAFEs—to create a tailored solution. Each of the financing “tools” serves a distinct purpose and can evolve as the startup matures. In this guide, we break down why startups pursue structured equity financing, the key advantages and disadvantages, and the things to consider when deciding whether this form of financing is right for your startup. Let’s dive in!

Structured equity financing - the basics

What structured equity financing is (and isn’t)

Structured equity financing is a flexible type of capital that provides startups with the liquidity they need to grow while minimizing their overall dilution. This approach combines multiple instruments such as convertible notes, preferred stock, and Simple Agreement for Future Equity (SAFE) to maximize flexibility, valuation, and risk mitigation. By tapping multiple tools simultaneously, startups can strategically position themselves for sustainable and scalable growth. You can think of it working similarly to unitranche debt, which combines senior and subordinated debt in a single instrument.

How structured equity financing works

Structured equity financing is similar to traditional equity financing, except that multiple structures of financing are combined. As mentioned above, the three main vehicles pursued in this strategy include convertible notes, preferred stock (traditional venture capital), and SAFEs, we’ve broken down each of those in a bit more detail below.

• Convertible notes - resemble short-term loans, allowing startups to borrow capital with an agreement that the debt will convert into equity when specific conditions are met. This flexibility is particularly advantageous during the early stages when a precise valuation may be challenging. For more information, check out the ultimate guide to convertible notes.
• Preferred stock -  this is the traditional venture capital process, we all know and love. In exchange for equity in the startup, investors provide capital (often in tranches). For more information, check out the ultimate guide to equity financing.
• SAFE - a more modern addition, simplifies the process. It is essentially an agreement between the startup and an investor, allowing the latter to invest in the company now with the promise of receiving equity in the future, usually during a subsequent funding round. For more information, check out the ultimate guide to SAFE note financing.

The structured (and stacked) nature of this financing method allows startups to customize their funding strategy according to their growth stage, industry dynamics, and specific goals. By utilizing structured equity financing, startups gain the advantage of adapting their financial strategy to match the intricacies of their business journey, fostering sustainable and strategic growth.

Common terms you may encounter while raising structured equity financing

Outlined below are some of the common terms you may encounter while raising structured equity financing. These terms shape the dynamics between investors and founders and define the rules governing the relationship.
Conversion Ratio: The ratio at which convertible securities, like convertible notes, convert into equity shares. It defines the relationship between the amount of debt held and the equity received.

• Valuation Cap: A predetermined maximum valuation at which convertible securities can convert into equity. It acts as a safeguard for investors, ensuring they receive a fair share even if the startup's valuation increases significantly.
• Liquidation Preference: Specifies the order in which investors receive payouts in the event of a liquidation or exit. For more information, check out the ultimate guide to liquidation preferences.
• Anti-Dilution Provision: A protective measure for investors, especially in the context of preferred stock. It adjusts the conversion ratio if new shares are issued at a lower valuation, preventing dilution of the investor's ownership stake. For more information, check out the ultimate guide to anti-dilution protection.
• Drag-Along Rights: Rights that allow majority shareholders to force minority shareholders to join in the sale of the company. This can be a protective mechanism for investors, ensuring a unified approach to significant decisions. For more information, check out the ultimate guide to drag-along rights.
• Tag-Along Rights: Conversely, these rights protect minority shareholders, enabling them to join in the sale of the company if majority shareholders decide to sell. It ensures minority shareholders aren't left out of potential opportunities.
• Pro Rata Rights: Rights that allow existing investors to participate in subsequent funding rounds to maintain their proportional ownership in the company. This helps maintain the balance of ownership among existing investors. For more information, check out the ultimate guide to pro-rata rights.

Common use cases for structured equity financing

• Seed Funding for Early-Stage Startups: Convertible notes or SAFE agreements are often combined due to their simplicity and adaptability in the early stages. 
• Bridge Financing: convertible notes or extension rounds can be combined to provide the cash cushion needed to raise the next equity round. 
• Mergers and Acquisitions (M&A): Structured equity financing can play a role in negotiating favorable terms during acquisition discussions. 
   

Assessing whether  structured equity financing is right for your startup

Advantages of raising structured equity financing

The main advantages of structured equity financing are that is very flexible (in terms of sizing, and structure), the financing can be customized to suit the needs of virtually any startup, and like traditional venture capital, it aligns the interests of the startup with the investors.

• Flexible: Structured equity financing, especially through instruments like convertible notes, offers startups flexibility in converting debt into equity. This adaptability is beneficial during uncertain growth phases and evolving valuation scenarios.
• Customizable: Structured equity financing allows startups to tailor their funding strategy according to their growth stages. Whether in the seed phase or later stages of expansion, startups can choose instruments that align with their specific needs at each juncture.
• Alignment of Interests: By offering various financial instruments, structured equity financing aligns the interests of investors and founders, creating a symbiotic relationship.

Disadvantages of structured equity financing

• Slow to Fund - Compared to debt financing, structured equity financing, can take a while to negotiate and secure. This is to do the complexity of the structure and the related agreements.
• Expensive - equity financing, all things equal is the most expensive form of financing available due to dilution. Upon exit, a few percentage points of equity can be worth hundreds of millions of dollars.
• Restrictive: Certain structured equity instruments, come with built-in investor protections. While these protections safeguard investors, they may limit the flexibility of founders and impact their decision-making autonomy.
• Risk of Down Rounds: In the event of subsequent funding rounds occurring at lower valuations, investors with anti-dilution protections (common in structured equity) may be entitled to adjustments, potentially leading to a down round. This situation can be financially challenging for the startup.

Qualifications required for structured equity financing

Qualifying for structured equity financing involves factors, which can vary depending on the startup's stage, industry, and growth potential. Generally, startups seeking structured equity financing should be post-revenue, have positive unit economics, strong revenue growth, and a robust management team. They should have a well-defined plan for the use of funds, and models that justify the amount of capital they are seeking. Typically it is not suited for early-stage startups, which would be a better fit for traditional venture capital.

Frequently asked questions (FAQs) about structured equity financing

How is the valuation cap determined during the structuring process?

The valuation cap is determined through negotiations between startups and their investors. It reflects the maximum valuation at which convertible securities can convert into equity.

How can startups mitigate risks associated with structured equity financing?

Startups can mitigate risks by carefully negotiating terms, setting appropriate valuation caps, and selecting instruments that align with their growth stage. Legal counsel and transparent communication with investors also contribute to risk management.

Can you explain the concept of conversion ratios in structured equity financing?

Conversion ratios determine the number of equity shares that convertible securities, such as convertible notes, will convert into.

What are the common terms one might encounter when negotiating structured equity financing?

Common terms include conversion ratios, valuation caps, liquidation preferences, anti-dilution provisions, and various investor rights such as drag-along rights, tag-along rights, and pro-rata rights.

How does structured equity financing align with different stages of a startup's growth?

Structured equity financing can be customized to align with different growth stages, from seed funding to later-stage expansion. It allows startups to choose instruments that suit their evolving financial needs.

In what situations is structured equity financing more suitable than other funding options?

Structured equity financing is often preferred when startups require flexible conversion terms, or when they are seeking a tailored funding approach that aligns with their growth stage.

Wrap up - raising structured equity financing in 2024

Structured equity financing is a versatile tool for startups across the growth spectrum. It is flexible, scalable, and customizable to the unique needs of each startup. However, it takes a fairly long time to find the right partners and structure the right terms. Like other forms of equity financing, it is also very expensive and can be restrictive to the operations of the startup. Ultimately, we’re fans of structured equity financing for startups that have positive unit economics and a clear plan for their next phase of growth.

If you’re interested in structured equity financing, get in touch!