One of Citizenfin’s main goals is to make the process of receiving funding for your startup as simple as possible. Making sure that startup entrepreneurs are aware of the core concepts underlying venture capital is the first step in achieving this goal.
It would be good if everything could be explained in a single paragraph and be very straightforward. That’s not doable, unfortunately, as with the majority of legal issues. This is only a very high-level review; nonetheless, it is worthwhile to read more about the specifics, advantages, and disadvantages of the various financing options as well as, most significantly, the critical aspects of such arrangements that you should be aware of, such as preferences and option pools.
The majority of venture financing occurs in “rounds,” which historically have names and a set order. A seed round comes first, followed by a series A, series B, series C, and so on until an acquisition or initial public offering (IPO). There is no requirement for any of these rounds; for instance, some businesses will launch with a Series A investment, which is nearly invariably a “equity round” as defined below. Remember that this article is solely focused on the seed round, the very first venture round.
At least in Silicon Valley, the majority of seed rounds are currently set up as convertible debt or straightforward arrangements for future equity (safes). Early rounds still occasionally involve equity, but they are becoming the exception rather than the rule in Silicon Valley.
Convertible notes
A loan that an investor makes to a business using a tool called a convertible note is referred to as convertible debt. The loan will have three components: a principal amount (the amount invested), an interest rate (often a minimum rate of around 2%), and a maturity date (when the principal and interest must be repaid). This note is intended to convert to equity (thus the term “convertible”) when the company completes an equity financing. Additionally, these notes typically include a “Cap” or “Target Valuation” and/or a discount. Regardless of the value of the round in which the note converts, a Cap is the highest effective valuation that the note’s owner will agree to pay. Due to the cap, investors in convertible notes typically pay less per share than other investors in the equity round. Similar to this, a discount establishes a lower effective valuation by subtracting a certain amount from the round valuation. Both of these stipulations, which investors view as their “seed premium,” are adjustable. Investors are frequently ready to extend the maturity dates on notes, however convertible debt may be called at maturity, at which point it must be repaid with accrued interest.
The Benefits of Convertibles
- Legally speaking, convertible note financing is easier to accomplish, indicating that it is more economical and easier to implement.
- Convertible notes make an effort not to value the startup, which can be beneficial, especially for seed-stage organizations that lack the necessary operational experience to establish an accurate valuation.
- These notes make excellent options for intra-round or bridge capital financing.
The Drawbacks of Convertibles
- The convertible note will continue to be a debt and eventually need to be recovered if successive value modifications are not completed. This might force businesses into bankruptcy.
- When gone too far, avoiding the terms and conditions results in negating the objective of the convertible note, which requires just as much effort and time as a typical value round.
- By safeguarding value assumptions, specific stipulations like the valuation cap and the conversion discount make future value hikes more difficult.
SAFE
SAFE, the S stands for simple.
Without the interest rate, maturity, and repayment requirements of convertible debt, a safe performs the same functions. Almost always, the only terms of a safe that may be altered are the amount, the cap, and the discount, if any. Any convertible security has a little additional complexity, much of which is determined by what happens during conversion.
Simply explained, it’s a financial instrument that allows you to raise money through a pricing round in exchange for the investor’s payment now and the company’s promise to issue shares to the investor at a later time. With a SAFE, there are hardly any negotiations. There are really just two issues you’ll likely negotiate with the investor: the amount of money you’re going to invest and the investor’s investment in the company’s valuation cap. Therefore, those two issues should be discussed during negotiations. When you contrast that with a pricing round, there are many more topics to discuss. And because of this, price rounds are much more difficult to close and raise money on than SAFEs are. Because of this, businesses frequently begin with a SAFE and then, after they are able to raise more money and have a lead investor with whom they can negotiate the pricing round, convert the SAFEs into shares so that they may benefit from the terms agreed upon with the lead investor.
Additionally, keep in mind that a SAFE is not a debt. Therefore, some of you may have raised money for so-called convertible debt. That instrument is different. Debts typically have an interest rate linked to them as well as a maturity date by which they must be repaid. Neither of those are present in SAFEs. It’s crucial to recognize that there are differences between the two instruments, but there are also some parallels in the manner that they convert in a pricing round.
EQUITY
In an equity round, you issue and sell new shares of the firm to investors after determining your company’s valuation (usually, the cap on the safes or notes is regarded as a company’s notional valuation, however notes and safes can also be uncapped). This explains why they are so popular for early rounds even though they are always more difficult, expensive, and time-consuming than a safe or convertible note. Additionally, it explains why you should always consult a lawyer before issuing equity.
An easy illustration clarifies what occurs when fresh equity is issued. Let’s say you raise $1 million based on a $5 million pre-money valuation. In the event that you also have 10,000,000 shares outstanding, the shares are being sold at:
$5,000,000 divided by 10,000,000 is 50 cents each share.
and you’ll sell as a result.
two million shares
new share total as a result is…
12,000,000 shares (10,000,000 plus 2,000,000)
and a post-funding assessment of….
$0.50 * 12,000,000 Equals $6,000,000
as well as diluting…
2,000,000 / 12,000,000 = 16.7%
Not 20%!
When your firm conducts a priced equity round, you need to be knowledgeable about a number of key elements, such as equity incentive schemes (option pools), liquidation preferences, anti-dilution rights, protective provisions, and more. All of these factors are negotiable, but in most cases, if you and your investors have agreed on a valuation (see the section after this one), you are not too far apart and a deal may be reached. Given that equity rounds are so uncommon for seed rounds, I won’t say any more about them.