Financing a great idea

With most new enterprises, there is a runway between time of inception to business sustainability. Depending on the goals of the enterprise, financing through investment can be a good option for bridging this gap.

But how do you best finance a good idea? It really depends on the idea:

For-profit enterprises

The model for initial stage financing for for-profit enterprises in Silicon Valley is fairly well known. While there is vocal discussion and even strong disagreement about whether the strategy is wise or fair to companies and their investors, the general approach is for a company to issue convertible notes to first stage investors and then two-to-three years later, seek large scale financing in the form of angel or venture capital investment.

  • A convertible note is a form of debt that converts into company ownership (hence the term “convertible”), typically after an 18 to 36 month window. The note provides flexibility to both the entrepreneur and the investor, as terms typically permit the entrepreneur to pay back the loan, convert the investor into a common owner, or convert the investor into a preferred owner in the event that a larger investor decides to invest in the company. The convertible note is not perfect: chief complaints are that it misaligns the interests of the entrepreneur and the investor, and that it does not adequately compensate the investor for the risk of investing in an early-stage company. Techcrunch has a good introductory series on the basics of convertible notes.
  • For-profits can also seek investment through “direct equity” investment. This means that the enterprise actually sells pieces of itself to investors in exchange for investment. Direct equity investors sometimes ask for control rights over the company (such as a board seat or an officer position) and typically also want preferential treatment with respect to their shares, in case the company is liquidated. Direct equity investors may also be granted preferential voting rights. All of these terms are subject to negotiation and really depend on the bargaining power of the entrepreneur versus his or her investors. Grants of direct equity are also subject to more detailed scrutiny by securities laws.

Non-profit enterprises

Historically, non-profits have been constrained in their operations by relying on grants or through individual fundraising efforts.  But these days, non-profits have found flexibility in funding through creative approaches:

  • Non-profit organizations that have not yet obtained tax-exempt status can reach out to “non-profit incubators.” A non-profit incubator is essentially an umbrella non-profit that can provide its tax-exempt status to the new entity, and even help the new entity with early stage organizational matters. Usually the non-profit incubator will take a small percentage of funds raised by the new venture to cover costs and expenses.
  • A non-profit can create a for-profit subsidiary (such as an LLC) and enter into a “joint-venture” with the LLC. The LLC can then sell ownership units to investors. There are strict tax rules governing the use of such joint venture arrangements, as undisciplined for-profit business practices may threaten the tax-exempt status of the non-profit organization.
  • Finally, non-profits can attempt to produce business income so long as such conduct does not become “unrelated business income.” Too much unrelated business income may be subject to tax and may even threaten the non-profit’s tax exempt status.

Sustainable / triple-bottom line / social enterprises

There is an emerging market and movement related to the growth of “sustainable” and/or “triple-bottom line” enterprises: companies that aim to make a profit while also taking into account the interests of the community, the environment, or the globe more generally. B-Corp certifications and the creation of Benefit and Flexible Purpose Corporation statutes are part of this larger trend of “social enterprise.”

Businesses seeking such a “triple bottom line” have a lot of flexibility with respect to funding sources:

  • Traditional investment models (such as the use of convertible note or direct equity funding) remain available to social enterprises that hope to achieve profitability. Investors can feel comfortable knowing they can obtain a return on their own investment while also fixing a social problem or creating a social benefit.
  • Social enterprises often experiment with membership or subscription models and are generally pioneer organizations with respect to crowdfunding platforms like KickstarterIndiegogo and Fundly. A social enterprise can convert its mission statement into consumer loyalty in a manner that traditional for-profit enterprises may find difficult.