Structuring Your First Financing Round
Once you’ve launched your business and identified investors who are interested in funding the venture, you’ll want to sort the optimal structure for your first financing round.
Most new businesses aren’t able to access the debt markets, so there are three primary investment structures used by new founders:
SAFEs:
The “simple agreement for future equity” (“SAFE”) was created by Y-combinator as a cost-effective means of bringing cash into a company before it can afford to conduct a full equity financing round.
By purchasing a SAFE, an investor is effectively “pre-paying” for shares of preferred stock that will be issued in a future financing round. As a result of the investor’s willingness to pay now for shares issued later, the price per share of the stock to be issued when the SAFE converts often receives some favorable economics, in the form of (A) a discount against the future round’s price per share and/or (B) a “valuation cap”, which is the maximum valuation that can be used in the future to calculate share price.
SAFEholders typically conduct limited due diligence and don’t receive any significant rights prior to their SAFEs converting.
Convertible Notes:
A convertible note combines the conversion features of a SAFE with the interest rate and maturity date of a classic promissory note. The maturity date establishes a deadline by which the company needs to conduct an equity financing round – or else the investor can call the note and receive their money back. The interest rate compensates investors for the time period during which they have loaned money to the company in exchange for future shares of stock.
Equity Financing Rounds:
For traditional venture start-ups, all roads lead to a priced equity round, in which the company sells shares of Preferred Stock at a price per share that implies a specific, negotiated valuation of the company.
During an equity round, all SAFEs and convertible notes will convert into shares of preferred stock.
The terms of a priced round are usually negotiated by a single “lead investor”, who invests a majority of the cash, conducts due diligence on the company and receives certain favorable rights (including, often, a seat on the Board).
The rights of the lead investor and other preferred stockholders are set out in a suit of documents – although the market generally uses forms that were created by the National Venture Capital Association (“NVCA”), the documents can be subject to extensive negotiation and customization, all of which can result in a priced round costing quite a lot.
Which do I choose?
Most founders who are raising cash pre-launch or pre-revenue prefer to use a SAFE or convertible note for their first round, as it minimizes the cost of the round and can push the equity valuation question into the future, when the growth and monetization of the company comes into focus.
Note, however, that a priced equity round can be essential in a scenario where the company has already raised one or more rounds on a SAFE or convertible note that includes a valuation cap – the effect of that valuation cap can be to amplify founder dilution if subsequent convertibles are stacked on top of the first round prior to conversion in an equity round.
Disclaimer: All of the information included in this website is provided for informational purposes only and should not be construed as legal advice. Please contact us for more information.