Debt Financing Options for Early-Stage Companies

By Michael Podesta, CPA, Audit Manager
ASL Emerging Business Group

Early-stage companies have several options when it comes to obtaining seed round funding; however, selecting the best vehicle for your company involves weighing the benefits and downsides of each option. Three popular debt-based financing vehicles are convertible debt, SAFE (Simple Agreement for Future Equity) agreements, and KISS (Keep It Simple Securities) agreements.

Convertible debt is the oldest, most complicated option and allows companies to raise capital by borrowing funds from investors at an established interest rate with a set maturity date. Principal and accrued interest convert into shares of company stock when the company enters into a qualified financing round. Convertible debt agreements typically have the most downside protection for investors as they may receive some or all of their principal investment upon maturity. However, these vehicles are the costliest to the company, because they require significant negotiation with investors, as well as the involvement of attorneys to assess legality of the agreement terms and to prepare the required documents.

SAFEs are the most simplistic of the three debt financing options and allow new companies to quickly obtain funding at a low cost. Companies can raise a set amount of funds from investors in exchange for an amount of company stock to be determined based on the next financing round. Unlike convertible debt, SAFEs do not contain interest or maturity dates and are not recorded as debt on the company’s balance sheet. SAFEs are considered the riskiest for investors of the three options. The higher risk is because the terms of the agreement do not call for the investment to be repaid to the investor and the possibility the company will not undertake a subsequent financing round, resulting in the investment never converting to equity shares.

KISSes are somewhat of a middle ground between convertible debt and SAFEs. While less costly and complex than convertible debt, KISSes are more complex than SAFEs. KISS agreements can be structured to either include a stated interest rate and maturity date, which leads to debt treatment, or exclude both to be treated as an equity investment. A KISS can be converted to company stock when the company raises at least $1 million in an equity financing or upon maturity by a majority vote of the KISS holders. KISSes also contain a MFN (Most Favored Nation) clause which allows the investor to modify his or her KISS agreement to receive the more favorable financing terms granted to investors in a subsequent round of financing. This MFN clause helps protect investors in the event the company has a “down round” in the future.

Each of these three financing vehicles can provide much needed funding to help your company grow and reach its goals. The selection of which option best fits your situation is a decision that must be determined by weighing the pros and cons of each and deciding which choice will be in the best interest of the company. For additional information or if you would like to discuss how these financing vehicles could help you accomplish your goals and benefit your company, please contact our Emerging Business Group with any questions you may have.