A Beginner's Guide to Funding and Capitalization Strategy - Types of Fundraising

Mar 28

The jargon surrounding funding, such as equity financing and capitalization strategy, can seem daunting at first. This article will provide the fundamentals of capitalization strategy and funding, including definitions of basic terms and recommended readings.

Types of funding

Commonly, there are two main types of funding that a stock company can opt for: equity and debt financing. Debt finance is technically a loan provided by an external lender, while equity finance is the process of raising capital by selling shares in the business (represented by shareholders' rights) to venture capital firms (like DIMENSION) and angel investors. Referred to as corporate finance, both types of leverage balance sheets (B/S) as insight into the organization's business/financial performance and credit ratings to raise funds for more development.

Characteristics of funding models

A loan is characterized by periodic payments of interest and repayment of the principal amount at the end of the predetermined loan term. A bank loan is shown in the liabilities section of the balance sheet. While interest rates on business loans have continued to stay low in recent years, the annual rate for new startups usually ranges from 1-2%. The interest rate they receive varies based on their business performance and track records. Banks typically look at audited financial statements and the latest operating performance of a borrower when they make lending decisions. When reviewing a loan request, banks specifically focus on the historical business performance of the firm to determine the likelihood of credit risk and the capacity to repay the loan. This helps reduce defaults and keep bad debt (uncollectible debt) levels in check. Business loans usually carry the following conditions.

Loan terms, repayment conditions
Collateral vs non-collateral loan (for example, is the loan co-signed by a director or not?)
Loans guaranteed by a credit guarantee corporation (CGS)* and loan with no public guarantee (non-CGS loans)

* Public credit guarantee scheme (CGS): A form of government intervention where public institutions, known as credit guarantee corporations, seek to facilitate access to debt capital for small and medium-sized enterprises (SMEs) by repaying the owned amount to the lender upon default of the borrower. Many startups with a short credit history and operational track record often seek financing through this guarantee program. In exchange for the guarantee, a credit guarantee fee/premium will be imposed on the lender, which is considered an expensive cost of debt compared with a regular loan's. Non-CGS supported bank loans are, as the name suggests, not supported under the CGF program. Non-CGS loans will become available once the startup business has a certain proven track record of success.

Seed-stage startups with no track record still have access to the capital needed to get off the ground and grow, as there are "startup loans" available for companies in their early stages of business. For example, Japan Finance Corporation (JFC) and other financial institutions do offer this financing option, which is opted by many early-stage startups.

Characteristics of Shares

The main characteristic of equity financing is that it carries no repayment obligation. Equity capital is shown in the equity section of the balance sheet, which does not require any debt payment. Investors are issued new shares in exchange for their investment.

To make the idea of stock issuance clearer, we will use an example below. When starting a new joint-stock business, the founder needs to make an initial capital contribution. If a stock company that has issued 9,000 shares decides to issue 1,000 new shares for ¥10,000/share (giving the company a pre-market cap of 90 million yen) to raise 10 million yen (post-market cap of 100 million yen), buyers of the newly issued shares will own 1,000 shares ÷ 10,000 shares (the new total number of shares) = 10% of the total number of shares issued.

When a company issues additional shares of stock, it can reduce the ownership percentage of existing shareholders, also known as stock dilution or equity dilution. In the above example, the founder's equity has been diluted from 100% to 90% (calculated by 9,000÷10,000 shares). In short, the total capital of a company is divided into small equal units called shares. Shares represent fractional ownership in a corporation that issued them. The capitalization table (or cap table) is an important document that clearly lists who owns how many shares, the proportion of each investor's ownership, the value of shares, and how much the business is attempting to raise. Venture capitalists will want to review a startup's cap table before considering an investment.

Shareholders are entitled to two main rights under Japan's Corporate Law. Specifically, shareholders may exercise their economic rights (also known as the rights to self-interest, including the rights to receive dividends and a distribution of residual assets of the company upon liquidation) and the rights of co-administration and supervision at shareholders' general meetings (also known as the rights to common interest, including voting rights to pass crucial decisions of corporate policy).

Given this, it is a critical decision for stock issuers to decide to whom and how many shares are to be offered, as the company grants its shareholders rights that are salient to the management of the company, i.e., equity, in return for raising capital that does not require repayment.

In Japan, the detailed procedures for the issuance of stock, as well as shareholders' rights, are stipulated by the Corporate Law. If you would like to know more details, check the Corporate Law, 4th Edition (commonly known as "LEGAL QUEST").

Common types of equity accounts

Seed-stage financing options for startup founders include J-KISS, deemed preferred stock, convertible notes, and common stock. Preferred stocks are more common in Series A and greater rounds.

Later in this series, we will dive further into some details of each type.