Startup founders must understand the basic concepts behind venture financing.
It would be nice if this was all very simple and could be explained in a single paragraph. Unfortunately, as with most legal matters, that’s not possible. Here is a very high-level summary, but it is worth your time to read more about the details and pros and cons of various types of financing and, importantly, the key terms of such deals that you need to be aware of, from preferences to option pools.
The articles below are a decent start:
Venture Hacks / Babk Nivi: Should I Raise Debt or Equity
Fred Wilson: Financing Options
Mark Suster: Convertible Debt
Venture financing usually takes place in “rounds,” which have traditionally had names and a specific order. First comes a seed round, then a Series A, then a Series B, then a Series C, and so on to acquisition or IPO. None of these rounds are required and, for example, sometimes companies will start with a Series A financing (almost always an “equity round” as defined below). Recall that we are focusing here exclusively on seed, that very first venture round.
Most seed rounds, at least in Silicon Valley, are now structured as either convertible debt or simple agreements for future equity (SAFEs).
Some early rounds are still done with equity, but in Silicon Valley they are now the exception.
Convertible Debt
Convertible debt is a loan an investor makes to a company using an instrument called a convertible note. That loan will have a principal amount (the amount of the investment), an interest rate (usually a minimum rate of 2% or so), and a maturity date (when the principal and interest must be repaid). The intention of this note is that it converts to equity (thus, “convertible”) when the company does an equity financing. These notes will also usually have a “Cap” or “Target Valuation” and / or a discount.
A Cap is the maximum effective valuation that the owner of the note will pay, regardless of the valuation of the round in which the note converts. The effect of the cap is that convertible note investors usually pay a lower price per share compared to other investors in the equity round. Similarly, a discount defines a lower effective valuation via a percentage off the round valuation.
Investors see these as their seed “premium” and both of these terms are negotiable. Convertible debt may be called at maturity, at which time it must be repaid with earned interest, although investors are often willing to extend the maturity dates on notes.
SAFE
Convertible debt has been almost completely replaced by the SAFE at leading incubators. A SAFE acts like convertible debt without the interest rate, maturity, and repayment requirement. The negotiable terms of a SAFE will almost always be simply the amount, the cap, and the discount, if any. There is a bit more complexity to any convertible security, and much of that is driven by what happens when conversion occurs.
Equity
An equity round means setting a valuation for your company (generally, the cap on the SAFEs or notes is considered as a company’s notional valuation, although notes and SAFEs can also be uncapped) and thus a per-share price, and then issuing and selling new shares of the company to investors.
This is always more complicated, expensive, and time consuming than a SAFE or convertible note and explains their popularity for early rounds. It is also why you will always want to hire a lawyer when planning to issue equity.
Example: To understand what happens when new equity is issued, a simple example helps. Say you raise £1,000,000 on a £5,000,000 pre-money valuation. If you also have 10,000,000 shares outstanding, then you are selling the shares at:
1. £5,000,000 / 10,000,000 = 50 pence per share and you will thus sell...
2. 2,000,000 shares resulting in a new share total of...
3. 10,000,000 + 2,000,000 = 12,000,000 shares and a post-money valuation of...
4. £0.50 * 12,000,000 = £6,000,000 and dilution of...
5. 2,000,000 / 12,000,000 = 16.7% Not 20%!
There are several important components of an equity round with which you must become familiar when your company does a priced round, including equity incentive plans (option pools), liquidation preferences, anti-dilution rights, protective provisions, and more. These components are all negotiable, but it is usually the case that if you have agreed upon a valuation with your investors (next section), then you are not too far apart, and there is a deal to be done. I won’t say more about equity rounds, since they are so uncommon for seed rounds.
One final note: whatever form of financing you do, it is always best to use well-known financing documents. These documents are well understood by the investor community, and have been drafted to be fair, yet founder friendly
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