For most founders, raising funds is an essential part of the startup journey. While how much capital you raise depends on many factors, such as your vertical, stage, traction, and growth plan, the types of investment vehicles available are relatively consistent. Understanding each funding approach, and its suitability to your startup, is essential for any founder planning to scale.
Investment vehicles are differentiated, in large part, by the investor’s risk appetite and expected return. This also influences where each vehicle fits in your capital stack. Startups typically rely on multiple funding vehicles throughout the lifecycle of their business, and the capital stack encompasses all of them, ranging from the lowest risk capital (i.e. debt) (at the top of the stack) to highest risk (at the bottom).
This article explains two common investment vehicles—equity and debt—as well as newer, and increasingly popular tools, convertible debt (CD) and Simple Agreements for Future Equity (SAFEs).
- Startups have access to different investment vehicles such as equity, debt, convertible debt, and SAFEs. Founders need to comprehend each option and its impact on their business.
- Equity funding involves trading ownership for capital, usually through common or preferred shares. Preferred shares, often chosen by investors, come with certain rights and rank higher in the capital stack.
- Startups can opt for conventional debt or venture debt. Conventional debt is a standard loan, while venture debt includes a warrant position, aligning the lender’s interest with the startup’s growth.
- Convertible debt and SAFEs offer alternative funding for startups. Convertible debt can be transformed into equity, while a SAFE investment vehicle provides quick funding without immediate valuation concerns.
Selecting the appropriate mix of investment vehicles is crucial for a startup’s lifecycle. Founders should seek professional advice to understand the long-term implications of each funding option.
What is equity for a startup?
Equity is probably what most founders consider when they begin efforts to raise capital. With this investment vehicle, the founder gives ownership (equity) to the investor or venture capitalist (VC) in exchange for capital to fund the business. Typically, the investors become part-owners of a business through the purchase of shares, with the goal of maximizing the economic value of their investment. This is where the type of share comes into play.
Preferred shares vs. common shares
Startups usually issue two types of shares: common and preferred shares. Both are direct claims on the equity of the business (once the preferred shares are converted). Founders and their employees tend to own common shares, which confer voting rights (usually one vote per share.) Investors, however, will likely negotiate preferred shares as part of the deal. Preferred shares rank higher than common shares in the capital stack. They are purchased in an unconverted state and will become common shares at some point and given a certain situation—usually at a conversion event that most benefits the investor.
While preferred shares do not confer formal voting rights, they may come with monetary rights not granted to common shareholders and usually certain consent rights. Such features may include liquidation preferences (that ensure investors are getting at least a predetermined return—usually a multiple of their investment), and anti-dilution provisions (allowing investors to keep their ownership percentages intact even if new shares are issued.) Because these additional rights can have a significant impact on your business, founders should review them thoroughly, keeping in mind the benefits of preferred shares are proportional to the inherent risk of investing in an early-stage startup.
While common shares are at the bottom of the capital stack, preferred shares sit just above them because they are considered relatively high risk for investors (but less risky than common shares due to the preferential treatment.)
Taking on debt: conventional vs. venture
In contrast to equity investments, conventional debt is a loan to a startup that must be paid back, with interest. Typically, it does not participate in the upside of a startup’s growth nor impact your ownership (unless warrants are present.) Debt sits at the top of the capital stack because it is paid ahead of equity holders.
A business usually pays the principal and interest with funds earned from operations or other financial partners. But since most startups are cash-burning (with little to no operating profit to immediately repay loans) how do they access this? That’s where venture debt comes in.
What is venture debt?
Similar to conventional debt, venture debt bears an interest rate and gets priority over equity investors. However, it also comes with a nominal warrant position—this gives the investor the right to buy company shares in the future at a pre-established price. Because the investor has the potential to share in the company’s future success, the lender and the startup are aligned on its growth.
A venture debt loan is not underwritten to positive cash flow, but lenders will typically consider startups that are backed with bonafide venture capital. VCs are heavily committed to the success of the startups they invest in, often funding a company over multiple rounds and years. This provides venture debt lenders with the confidence that a startup is relatively solvent and poised for growth. Venture debt investors focus on the company’s cash position and ability to raise further rounds to service the debt (principal and interest).
Why should a startup consider venture debt?
If a startup has venture capital, then what’s the value in securing venture debt, as well? A typical VC round provides a startup with 18 to 24 months of runway to meet milestones and access funding from investors. Venture debt bolsters the balance sheet of a startup which can extend the runway even further. This, essentially, grants a startup breathing room to reach critical revenue and growth goals.
More funding approaches for startups: convertible debt and SAFEs
Early stage investors have created innovative ways to fund startups without the heavy due diligence or formal valuations required for debt and equity. These novel approaches are steadily gaining traction. The two main types are convertible debt (CD) and Simple Agreements for Future Equity (SAFEs).
What is convertible debt?
Convertible debt, also known as a convertible note, is an interest bearing loan similar to venture debt, but instead of repaying the full amount, the investor has the option to convert some or all of the loan to equity if certain conditions are met.
How does convertible debt work for startups?
The most common condition is when the company raises qualified equity financing within the term of the debt (typically 24 months). Convertible debt also includes a valuation cap which sets the maximum price per share that the investor will convert at, regardless of how much the company grows during the term of the debt. This makes CD more attractive to investors. When Peter Thiel invested $500K in Facebook, he did so via convertible debt with a valuation cap of roughly $5 million. Facebook then raised almost $100 million on the next round, thus granting Thiel about 10 per cent of the company. Without the valuation cap, Thiel would have only owned 0.5 per cent.
This investment vehicle can also come with a “discount rate” off the next round’s share price. The feature is typically in place of the valuation cap, meant to provide the investor with a benefit if the valuation is below the cap upon conversion. Convertible debt converts at either a cap or a discount, but usually not both.
Are convertible notes good for startups?
Ideal for bridge financing a startup, CD can provide a runway extension to help a company reach the next equity round. If the company hasn’t reached its goals, for example, the bridge round can delay revaluing the company to avoid a down-round (a lower valuation than the previous round.)
What is a SAFE?
SAFEs, or Simple Agreement for Future Equity, are primarily used by angel investors and accelerators to provide capital to seed stage startups. They’re straightforward single document agreements that can fund a company quickly.
What are the benefits of a SAFE agreement?
One of the benefits to a SAFE investment vehicle is that it isn’t reliant on your company’s current valuation—making it ideal for early stage startups. Instead, valuations are delayed to a future date, usually after raising capital and the company has increased in value.
Why do startups use SAFEs?
A SAFE round investment is considered founder-friendly because they lack the loan resemblance of convertible debt and there are no interest rates. It’s a high risk investment, which is why investors get some preferential treatment. Similar to convertible debt, an investor has the right to convert to common shares at a valuation cap, or a discount.
Finding the right mix of investment vehicles for your startup
Founders typically rely on various investment vehicles throughout a startup’s lifecycle. Because they vary based on the risk appetite and expected return of investors, a vehicle that’s appropriate during your company’s early stage may not be a good fit further along the lifecycle. To find the ideal mix of funding options (eg. venture debt vs. convertible note), founders should explore all funding vehicles and take the time to understand how each may impact their business. It’s highly recommended you speak with a lawyer to make informed decisions.
Frequently asked questions about investment options for startups
What is a SAFE investment vehicle?
A SAFE, or Simple Agreement for Future Equity, is a legal document used in early-stage fundraising, often by angel investors and accelerators, to provide capital to a startup in exchange for equity in the company at a later specified date. It’s designed to be a simpler and quicker alternative to traditional equity financing. The key characteristic is that the valuation of the business is deferred until a later funding round, avoiding the need to determine the company’s value at the time of the initial investment.
What does SAFE stand for in investing?
In the context of investing, SAFE stands for “Simple Agreement for Future Equity.” It outlines the terms for an investor to receive equity in a startup at a later date, usually during a future financing round.
What is an example of a SAFE investment?
An example of a SAFE investment might state that upon a specific triggering event, such as a future funding round or an acquisition, the investor will receive equity. For instance, the agreement might include a valuation cap of $5 million. This means that when the startup undergoes a subsequent financing round, the SAFE investor can convert their investment into equity at a price per share not exceeding the $5 million valuation cap, regardless of the company’s valuation at that time. This provides the investor with potential upside if the company’s valuation increases.
Another notable example is Y Combinator-backed companies Dropbox and Airbnb who initially utilized SAFEs in their fundraising rounds before transitioning to more traditional financing methods as they scaled. Y Combinator, a prominent startup accelerator, popularized the use of SAFEs as an alternative to traditional seed funding instruments.
What happens if a SAFE never converts?
If a SAFE (Simple Agreement for Future Equities) never converts, it means that the specified triggering event for conversion, such as a future financing round, has not occurred. In such a scenario, the investor does not receive equity in the company, and the SAFE remains outstanding until a conversion event takes place or another resolution is agreed upon between the parties involved. The terms of the SAFE document typically outline the conditions under which conversion can happen, and until those conditions are met, the investor retains the right to convert the SAFE into equity in the future.
What is the difference between a SAFE and a convertible note?
While both Simple Agreements for Future Equity (SAFEs) and convertible notes are investment vehicles used in early-stage startup funding, they have some key differences:
- Debt vs. Equity:
- Convertible Note: Functions as a debt instrument with a maturity date and an interest rate. It converts into equity (usually preferred stock) during a subsequent financing round.
- SAFE: Does not represent debt or accrue interest. It is an agreement for the future issuance of equity, typically during a future financing round.
2. Interest and Maturity:
- Convertible Note: Usually carries an interest rate and a maturity date by which the note must either convert to equity or be repaid with interest.
- SAFE: Does not have an interest rate or maturity date. It converts to equity when a specified event occurs, usually in the form of a future financing round.
- Convertible Note: Typically has a valuation cap or discount to determine the conversion price during the subsequent funding round.
- SAFE: Usually does not have a valuation cap, but it may have other terms influencing the conversion price.
4. Legal complexity:
- Convertible Note: Generally more complex with legal documentation, including repayment terms, interest calculations, and conversion mechanics.
- SAFE: Designed to be a simpler document, with fewer terms and complexities, making the negotiation and closing processes quicker.
5. Timing of Conversion:
- Convertible Note: Converts at a predetermined valuation during the next qualified financing round.
- SAFE: Converts at a future financing event, but may not have a predetermined valuation.
Who benefits from convertible debt?
Convertible debt may be a mutually beneficial financing option for both startup founders and investors. For startups, it offers quick access to capital without an immediate need for valuation. The flexible terms of convertible notes expedite the fundraising process, allowing startups to defer valuation discussions until a subsequent round. Additionally, these notes may accrue interest, providing an extra incentive for investor participation.
Investors benefit from the potential conversion of debt into equity, often at a discount or with a valuation cap during a subsequent financing. Convertible debt holders face lower risk in case of startup failure, as they have a higher claim on assets during liquidation compared to equity holders. Furthermore, investors enjoy the opportunity to reap the rewards if the startup performs well and experiences a successful financing round or exit event.
What is an example of a convertible debt offering?
An example of a convertible debt offering for a startup is Peter Thiel’s $500K investment in Facebook with a valuation cap of roughly $5 million. Facebook went on to raise almost $100 million on the next round, thus granting Thiel about 10 per cent of the company. Without the valuation cap, Thiel would have only owned 0.5 per cent.
Is convertible debt a liability or equity?
Convertible debt is initially recorded as a liability on a company’s balance sheet. This is because it represents a contractual obligation to repay the borrowed amount or convert it into equity at a future date.
Once the convertible debt converts into equity, it is reclassified from a liability to equity. The conversion typically occurs during a subsequent financing round, and the debt is exchanged for shares of stock in the company. At this point, the value of the debt is effectively transformed into ownership in the company, and it no longer represents a liability.
What is the difference between convertible debt and normal debt?
Convertible debt and normal (non-convertible debt) are both forms of financing, but they differ in key aspects, particularly in how they can be converted into equity. Put simply, convertible debt provides a hybrid financing option that combines elements of debt and equity, offering flexibility for both the borrower and lender. Normal or non-convertible debt, on the other hand, is a more traditional form of debt financing without the conversion feature.
Is 1% equity in a startup good?
Whether a one per cent equity stake in a startup is considered “good” can vary based on the specifics of the company and the individual’s perspective. Some considerations include the startup’s stage, valuation, industry norms, your role and contribution to the startup, and its potential for growth.
It’s essential to assess the specific circumstances and seek out advice from legal and financial professionals who can help to ensure a fair and informed evaluation.
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