When it comes to raising capital, there are many considerations and decision points: How much do you care about retaining control of the company? Do you want the right to pay investors back so that they cannot exert influence upon the company? How much time and resources can you allocate to fundraising?
The answers to these questions will likely influence which instrument you use to raise capital for your startup. This post provides a general overview of some of the options for your startup to receive investment. Knowing the basics about different financing structures will help you avoid coming across as a rookie when you start meeting with investors.
SAFE
SAFE is short for Simple Agreement for Future Equity, which is a perfectly descriptive title. The SAFE gives an investor the right to receive equity in the startup if and when certain predetermined conditions happen (usually the startup closing an equity investment round or getting acquired). A SAFE converts to equity based on the events defined in the SAFE, such as raising a certain level of equity investment. Many of the categorical terms found in SAFEs are also found in convertible notes; a SAFE may have a valuation cap (which affects the per share price to determine how many shares the investor gets at conversion), a discount (which also affects how many shares the investor gets at conversion), a most-favored nations clause (which gives the investor the right to more favorable terms offered to a subsequent investor), or a pro rata rights clause (which gives investors the right to participate in future fundraising). The SAFE is different than many other financing agreements, because it does not accrue interest and has no maturity date. Unlike a convertible note, a SAFE is not a promise to repay a debt so the investor does not have right to repayment, absent some triggering event.
Upside: Cheap, fast and not debt.
Downside: The SAFE is fairly new to the investment community outside of Silicon Valley. Some investors are not comfortable with SAFEs because SAFEs provide limited rights to investors; and, unlike convertible notes, SAFEs do not include traditional repayment provisions if the SAFE doesn’t convert into equity.
Convertible Note
In many ways, a convertible note works just like a SAFE. The balance due under a convertible note (amount invested plus accrued interest) is typically converted into company equity when a triggering event happens—usually an equity financing, liquidation of the company, IPO, or the convertible note’s maturity date. Similar to the terms in a SAFE, a convertible note may include valuation cap , discount rate, most-favored nations clause, or pro rata rights. Additionally, a convertible note financing may involve a note purchase agreement, which typically requires each party to make more comprehensive representations and warranties. A major feature of a convertible note is that it is considered debt and may require repayment at maturity. Unlike with a SAFE, you can’t say “tough luck” to the investors if the triggering event to convert the note to equity doesn’t happen.
Upside: Cheaper than equity, somewhat quick to close, and investors are familiar with the structure.
Downside: Considered debt, may require amendment or awkward discussions around maturity, and may not properly articulate the company’s value at the time of conversion.
Preferred Equity
Equity investment can come in many forms, the most traditional of which is preferred equity. In a preferred equity financing, the investor purchases preferred stock (a different class than common stock) at a set per share price. Preferred equity typically provides an investor special rights over and above the rights afforded to common stockholders. Those rights include a liquidation preference, dividend rights, pro rata rights, rights of first refusal, co-sale rights, director appointment rights, and protective provisions – we'll cover those in more detail in future posts. In other words, investors in equity rounds generally gain a whole slew of rights that SAFE and convertible note investors would not likely receive. A founder who is concerned about maintaining control of his or her company should carefully weigh the rights given to investors in a preferred equity round. Additionally, it should be noted that equity investment through the sale of common stock is much more favorable to the company, but it is very unlikely to happen, because it bucks the norms that have been established for startup investment. Investors expect the special rights associated with preferred stock in order to maximize their ROI (return on investment). Your company might be your life, but it’s all a numbers game for investors at the end of the day.
Look for more on these topics in the coming weeks!
*This blog provides general information for educational purposes only. It is not intended to constitute specific legal advice and does not create an attorney-client relationship.*