Direct Equity, SAFE or Convertible Note?

A common dilemma for start-up founders based on my personal interactions with them overtime has been to decide which instrument is best employed to secure financing for their growing startup, relative to the company’s stage of development. Somewhere in-between the internal deal review process, some founders would place a call to notify about their intention to adopt a different fundraise instrument, this could be funny and distracting. As competition for the available fund in the Venture Capital market increases, it is crucial for business owners to understand their fundraising options, first to enable them create a solid impression in the minds of investors, as well as to avoid being locked into a structure with potential medium or long-term downsides.

While each round of fundraise comes with detail-heavy intricacies, through this write-up I look to offer a brief overview and comparison of the three increasingly popular structures: Direct Equity, Convertible Note and the newer hybrid option, SAFEs (simple agreement for future equity).

Fundraising through direct equity has been a convenient way to quickly gain capital, especially if cash flow in the business is too unpredictable. This option is often best utilized by companies that have already undergone a seed round and are looking for larger raises (>$1 million rounds). However, I believe early stages founders should often avoid this option (if possible) in order to limit their dilution and also avoid the risk of overinflating the company’s valuation. Since investors are making a direct purchase of a portion of the company, both parties will need to agree on a pre-money equity price, If this option is deployed too early the company may be at risk of undergoing a “down round” (fundraise at a lower valuation) during its next capital raise which could create a messy situation for diluted equity holders and can have a chilling effect on recruiting new investors.

There are several other important components of a priced round, including equity incentive plans (option pools), liquidation preferences, anti-dilution rights, protective provisions, and more. These components are however all negotiable provided there is an agreement on a pre-money valuation between the lead Investor(s) and the promoters. From a control perspective, equity investors will frequently demand a board seat and veto rights regarding certain corporate actions (e.g., issuing any new class of equity, adjusting board size, change of control, amending governance documents). I recommend that founders should be willing to sacrifice a sizeable control in their company before entertaining this (Equity) fundraising option.

A convertible Note works best for seed round financing when the company expects to raise a larger amount of venture capital funding in the future. In general, the terms are governed by a convertible note, and a company receives money in the form of debt that can later be converted into equity upon the occurrence of certain triggering events. For example, the note may provide that all outstanding principal and accrued interest may convert into equity when the company engages in a future equity financing round of at least $1 million. The conversion price is often equal to around 80% of the price of the equity financing and may be subject to a valuation cap or ceiling. The valuation cap mechanism protects note investors against undervaluing a company at such an early stage, however, it could ultimately cause the company to issue equity at an undervalued rate in later financings.

Generally, the term of convertible notes can range anywhere from six months to two years, with interest rates around 6-10%. Upon maturity, some notes may automatically convert, while others may either provide for the investor to demand cash payments or accrue interest at a default rate. The second option could be self-destructive to a company that has no future investors or cash flow plan in mind. In sum, while a convertible note structure offers some advantages over a direct equity sale, it is most beneficial to a startup company that has a detailed strategy to engage institutional investors for a future priced round.

SAFE (Simple Agreement for Equity) instrument was introduced in 2013 by Y Combinator, the Silicon Valley accelerator, allowing startups to structure seed investments without interest rates or maturity dates. By contrast, a SAFE function like a warrant and it grants investor(s) the right to obtain equity in a future fundraising round. However, unlike a convertible note, a SAFE may convert with any amount of money to be raised in a future equity round instead of under certain qualifying transactions. The participation right can still be subject to a valuation cap, but there is no term or interest rate. Like a convertible note, a SAFE also has triggering provisions for early exits and dissolutions, notes can be paid out to the buyer if an acquisition or change of control should occur prior to the regularly expected conversion. Often, if there is a change of control, convertible note templates will give a 2x pay-out option as well as an equity conversion.

From an investor perspective, the lack of a maturity date may cause discomforts in certain scenarios. For example, if a company is doing well after a SAFE round and does not need to obtain future financing, then a SAFE may technically never trigger a conversion event. However, in such a scenario, it is more likely that the founders will be able to negotiate a fair process with the investors. Nevertheless, the founders will have the upper hand in such discussions.

After all said, whichever option is eventually settled for by founders, I personally believe that the long-term success of a venture-backed startup hinges on the ability of the promoters to raise follow on capital to finance research, fuel product development, discover product market fit and ultimately scale sales and valuation.

To succinctly wrap-up what I consider the most important principle of start up fundraising; 

"Raise enough money to achieve a set of milestones that will attract a subsequent round of investment from new investors, at a justified valuation”

Raise a seed round that will enable you to raise a Series A round. Raise an A to raise a Series B and so on.

Glossary

Conversion event: Set of conditions that precedes the conversion of a type of debt or hybrid financial instrument to equity.

Chilling effect: Inhibition or discouragement [of new participants].

Convertible Note: A form of short-term debt that converts into equity.

Down round: This is a situation where a company accepts a lower post-money valuation than at its previous financing.

Equity: A unit of ownership in a company.

Fundraise instrument: Types of contracts issued to investors in exchange for providing financing for startups.

Priced round: Equity investments based on a negotiated valuation of a company.

Seed financing: Also known as seed capital, seed money, or seed funding is the money raised to begin developing a business or a new product.

Series A round: This is one of the stages in the capital-raising process by a startup provides up to a couple of years of runway for a startup to develop its products, team and begin to execute on its go-to-market strategy.

Valuation cap: This is the maximum price that a convertible security will convert into equity.