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 investments (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).
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 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 investment vehicle? This is 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 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.
New 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, 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 Equities, 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 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?
SAFEs are 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, 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.
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