You’ve realized that you need to raise some cash to keep your startup humming along and take the next steps, whether that step is hiring a salesperson, launching the beta version of your product, or servicing your first large client. But you’re not so far along that you feel ready to launch a large round of financing with institutional investors, i.e., a Series A equity financing. There are a number of financing options for your early stage startup and the differences between them are likely to dictate which you’ll use.
The investors that are willing to fund your company at this stage are usually (i) angel investors that you know, (ii) incubators/accelerators or (iii) micro VCs (think mini-VC funds targeting seed investments). Sometimes your investor will dictate the fundraising vehicle you use so be clear on your priorities. Is it more important that you attract a specific investor that is well-connected in your industry but who insists on getting priced equity for their investment? Or are you reluctant to establish a valuation for your company at such an early stage? Or do you just need cash and you’ll take it in any form it comes? To help you navigate early stage financing, let’s review three commonly used options—Priced Equity Financing (e.g. Series Seed), Convertible Debt and SAFEs.
Priced Equity Financing
A priced equity financing, sometimes called a Series Seed financing in the early stage or a Series AA by some incubators, involves the issuance of preferred stock in exchange for an investment in the company. It can be thought of as a watered-down version of a Series A financing because it often lacks the more complex (and negotiable) terms that many VC investors expect in a Series A, such as dividend preferences, anti-dilution protections and robust protective provisions. On a conceptual level, it’s not that the Series Seed investors are so much as giving up standard VC rights as they are agreeing to delay getting them until a future financing.
Some entrepreneurs aren’t keen on using Series Seed at an early stage because it requires a valuation for your company. For example, if you raise $100,000 in exchange for 10% of your company, your company has a post-financing valuation of $1M. Or, if you end up selling 25% for $100,000, your company has a post-financing valuation of $400,000. There is some baggage to be aware of with a valuation. The lower the valuation ($400K vs $1M), the more dilution the founders will experience (you are giving up 25% of the company versus 10%) and so some entrepreneurs are leery of using equity at the very early stages of their company when it is still struggling to get off the ground. It also sets a valuation floor, meaning the next time you raise money your business should be generating enough traction to justify a higher valuation and therefore a higher price per share. If you can’t, things aren’t looking so good and your next financing may be a down round where you are forced to sell more of your company to raise a comparable amount of cash. On the flip side, certain investors will argue that a valuation brings more transparency and alignment to future capital raising. Everyone knows their price and you avoid any tension at the first equity financing where your early investors may be jockeying for a low pre-money valuation so that they end up with more of the company while your new investors may be pressuring the founders to renegotiate the conversion terms with your early investors.
What is the Required Documentation for a Preferred Equity Financing?
An issuance of preferred stock will require you to amend your certificate of incorporation (charter) to outline the rights of such stock, i.e., liquidation preference and conversion into common stock. This means getting the requisite stockholder consent and filing the amended charter with Delaware, in addition to documenting approval from your board of directors. The stock investment or subscription agreement will cover the economic terms of the investment and cover additional rights granted to the preferred stockholders. Sometimes the stock investment agreement will be broken out into two agreements—a purchase agreement and an investor rights agreement—which gets you to the same spot but with another set of signatures to obtain. Issuing preferred stock is often viewed as the early financing option that takes the most time and costs the most in legal fees.
Convertible Debt starts out as a loan that an investor makes to the company in return for a “promissory note”, commonly thought of as an “IOU”, that converts into equity at a future preferred equity financing. Since it is debt it needs a maturity date, which is when it is supposed to be repaid (but very rarely is), and an interest rate. It does not, however, need a valuation of your company. The key to Convertible Debt is the terms for the conversion. Many (but not all) deals have a discount ranging between 10% and 30% and a valuation cap as part of the conversion metrics. With a discount, the debt will convert into equity at a price per share that is discounted from the price per share paid by the new investors in the next equity financing. So a price of $1.00 per share for your equity investors becomes 80¢ for your Convertible Debt investors who have a 20% discount. This is meant to reward your early investors who took a risk on your company.
With a valuation cap, the investors are looking to effectively “cap” the dilution of their investment by establishing a maximum valuation that will apply to the conversion in the future equity round. You may be wondering “but they get a discount; isn’t that enough?” In some cases, yes, but if your company has a significantly higher-than-expected valuation during the equity financing, the Convertible Debt investor’s percentage ownership of the company could be pretty small at conversion, even with a discount. This risk may deter some investors from holding Convertible Debt, making valuation caps, like discount rates, important for keeping these instruments attractive to investors.
For Convertible Debt that includes both a discount and a valuation cap, how do you know whether the discount or the valuation cap applies? You’ll have to do the math, but the short answer is whichever conversion metric gives the Convertible Debt investor the most shares.
Convertible Debt with a valuation cap has its critics. Why? Because if the valuation during the preferred equity financing significantly exceeds the valuation cap, the Convertible Debt investors end up with a multiple liquidation preference, i.e., a larger return or multiple on their initial investment than the other Series A investors who had to pay a higher price for the same preferred shares (see the example below). The anti-dilution protection coupled with a multiple liquidation preference that can be gained with a valuation cap has led some to urge that Convertible Debt only be used as a true “bridge” (small, short-term funding from existing investors with a line of sight to your next equity financing) rather than for longer-term fundraising.
What is the required documentation for Convertible Debt?
Convertible Debt delays the issuance of equity to a future date so you don’t need to alter your charter. You do need a Convertible Promissory Note (the “IOU” that contains the terms of the debt and how and when it converts into equity) and a Note Purchase Agreement (listing all of the investors, the amounts invested, and containing representations and warranties given by the company). You’ll need to document board approval and some may also want to get stockholder approval for any Convertible Debt deal. Sometimes a statement signed by your Secretary and attaching the company’s charter, bylaws and approvals for the financing is provided to the investors for transparency purposes.
Simple Agreements for Future Equity (“SAFEs”) were created by Y Combinator and can be seen as an evolution of Convertible Debt. Like those instruments, SAFEs involve a cash investment into a company that will convert to equity at a future preferred equity financing. Unlike Convertible Debt, it isn’t debt and so doesn’t have a maturity date or an interest rate. A SAFE will simply remain outstanding until the conversion event occurs, making the instrument more low maintenance than Convertible Debt. As with Convertible Debt, a key decision is whether there is a discount and/or a valuation cap built into the conversion metric. While there is a version of the SAFE with neither a discount or a cap, you’d need to find an investor comfortable with funding you based on terms of a future (and unknown) equity financing.
The SAFE does try to address the consequence of giving your early investors a multiple liquidation preference with a valuation cap. With a SAFE, if the pre-money valuation at your preferred equity financing is higher than the valuation cap, the preferred stock that the SAFE investor will get has a price based on how much that investor actually invested in the company, and not the higher price in the preferred equity financing. This way the SAFE investor doesn’t get a liquidation windfall where the conversion gives him preferred stock that has a price that is much higher than the one he actually paid because of the cap. To accomplish this, the SAFE investor is given “shadow” preferred stock, meaning that while the equity investors get Series A preferred stock, the SAFE investor will get Series A-1 preferred stock so that the different prices can be captured, and they all get the same multiple based on the price actually paid by the investor (see the example below).
What is the required documentation for a SAFE?
The SAFE is a single-document instrument that requires little negotiation. Yes, you heard that right—one document (although you’ll still need board approval)! Because of this, it can be the fastest and the least costly types of financing to implement. There is a trade-off though; namely, with a SAFE, and especially if the investor is issued shadow preferred stock, your company’s capitalization table suddenly becomes more complex, which can lead to errors and the messiness that goes with them.
Looking at an Example of Convertible Debt and a SAFE
Convertible Debt and SAFEs (unlike a Series Seed) both involve conversion into Preferred shares when the company does have a priced equity financing round. To demonstrate how those two instruments differ on conversion, let’s look at an example:
Your Angel Investor puts $100,000 into the company with a $5,000,000 valuation cap and a 20% discount. You are now ready to issue $1,000,000 worth of Series A preferred stock at a $10,000,000 pre-money valuation with a price per share of $1.
If your Angel Investor bought Convertible Debt: With the 20% discount your Angel Investor would pay 80¢ per share and get 125,000 Series A preferred stock but with the valuation cap your Angel Investor would pay 50¢ per share ($5mm cap divided by $10mm pre-money valuation) and get 200,000 Series A preferred stock. The preferred outcome is getting 200,000 shares so after the financing that’s what they’ll own. Yet even though they effectively paid 50¢ for their shares, the shares they got are priced at $1 and that will be their liquidation preference (how much they’ll get back assuming the Series A is allocated a x1 multiplier). This results in a multiple liquidation preference for the Angel Investor who initial purchased convertible debt. If and when there is an exit, such as a sale or an IPO, your Angel Investor gets a larger multiple on their $100,000 initial investment than the other Series A investors who paid a higher price for the same class of shares, i.e., they get two times more than they invested because $1 liquidation preference x 200,000 shares = $200,000, whereas the other Series A investors simply get one times their investment.
If your Angel Investor bought a SAFE: With the 20% discount your Angel Investor would pay 80¢ per share and get 125,000 Series A preferred stock. Assuming the company’s fully diluted outstanding capital stock immediately prior to the financing is 11,000,000 shares, with the valuation cap your Angel Investor would pay 45.45¢ per share ($5mm cap divided by 11mm shares outstanding) and get 220,022 shares Series A preferred stock. An important difference here with the SAFE is that the Preferred Stock the Angel Investor would be issued is Series A-1 Preferred stock which is priced at 45.45¢, what they actually paid, and that would be the liquidation preference for those shares. This is how the SAFE tries to avoid the multiple liquidation preference issue with convertible debt. With a price per share that matches what was actually paid by that investor, she doesn’t get a windfall on an exit. Instead she gets what the other Series A investors are entitled to, a x1 liquidation preference or 220,022 x 45.45¢ = $100,000.
There are a number of options on the financing menu for any early stage company. Whether you think a Series Seed, Convertible Debt, a SAFE or something else is right for your company, having the different options is exciting. But having this many options is also a signal that none of them are perfect. So what’s even more exciting than having options is understanding the differences between them and the consequences that follow so that you can make an informed decision when financing your company!