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Running an early-stage startup has its fundraising challenges. Equity is something you should think about at the very beginning, when you are ready to start distributing stock to investors, employees, co-founders, and all relevant shareholders.
The reason you are distributing equity is to encourage those shareholders to continue growing the company. Having committed co-founders can mean the difference between a chaotic mess and a successful seed round.
Combining a powerful team with an in-depth understanding of the basics of equity is a powerful strategy for winning your next fundraising round.
What fundraising types are available?
Fundraising is the act of trading financial instruments with investors, in exchange for money. There are different types of these financial instruments that are linked to the equity of your startup.
Here is an overview of the differences between these financial instruments. Analyzing these will help you consider which terms of investment are right for your business.
SAFE Note
The acronym SAFE stands for “simple agreement for future equity”. This financial instrument is a single document that reserves equity for initial investors.
Unlike traditional debt, SAFE is free of interest rates. SAFE sets a final date to convert to stock or the debt will be repaid. It has no maturity date. SAFE was designed by Y Combinator, an
accelerator out of Silicon Valley.
They solved the problem of having to close with all investors simultaneously. SAFE allows
investors to purchase stock in a future priced round.
This means less time spent negotiating the terms. Closing can happen when both parties are ready to sign. There is only one factor to negotiate – the valuation cap of the startup. Visit the SAFE User Guide from Y Combinator for examples of how this works.
Convertible Note
A convertible note is a financial instrument that converts to equity at a trigger point, or set date of maturity. In that way, it is similar to a SAFE Note.
Convertible notes accrue interest until their maturity date. Once the maturity date arrives, the founder will need to begin paying the interest rate to the investor.
For new startups, convertible notes and SAFE Notes are simplified ways of fundraising. The co-founders don’t yet need to agree on a set company valuation. The terms are easily negotiated with individual investors, meaning that you can negotiate with more than one separate investor at a time.
The major difference between these terms of investment is the payment of interest. If you are starting your first round of funding, SAFE notes may be the best option for you.
Priced Equity
To sell priced equity, founders need to know the company valuation. This term of investment is best for startups with big cash needs who are ready for growth.
Before closing, be prepared to negotiate the company valuation with investors. Once
negotiations are complete, investors purchase new stock at a set price per share.
Priced round investors usually receive perks like priority payouts during liquidation. They will negotiate other preferential benefits during your priced round as well.
Completing priced rounds can be expensive and end in a loss of more autonomy than desired. You don’t have to price your equity before your startup is ready.
How can I select the right terms?
When you offer investment options, there are a few benefits you can offer your investors. Here are some of those benefits, and how they can impact your terms of investment.
Conversion Discount
Offering a conversion discount means the startup and investor agree on a discount rate on the valuation of the company. This discount determines the conversion price for the investor.
Allowing these discounts to increase over time is a great option that offers them more equity. Here’s how that might look:
● 12% if the Series A round occurs within 6 months of the note investment;
● 21% if the Series A round occurs within 7-12 months after the note investment; and
● 33% if it occurs 12 or more months after the note investment.
Conversion discounts give your investors a fair return for investing before any other round. They can have more shares as your company grows, and your company valuation does not
decrease.
You can offer conversion discounts with SAFE Notes, because they are both done before your Series A round of fundraising.
Interest Rate
Earlier we talked about paying an interest rate on your convertible notes. Interest rates are attractive to your investors because it ensures that they will receive a higher return than what they invested.
Interest rates for convertible notes cannot be under 2%. Otherwise, they will not be considered as debt instruments. 2% – 8% is a typical range for interest rates on convertible notes.
If your investors are seeking a higher interest rate, you can request a price cap. Before you
discuss the possibility of offering an interest rate, check in with your lawyer about usury laws.
Pro-Rata
The Latin phrase pro rata describes something being dealt out in proportionate amounts.
Dividends are paid on a pro rata basis. This means everyone receives their fair share of the
payout.
For example, you own 20% of your business, and 4 people owning equal shares the remaining 80%. That means each of those 4 shareholders has a 20% pro rata share.
Valuation Cap
A valuation cap is the maximum price at which an investment is converted into equity. This maximum is negotiated to make sure the investor does not lose out on any appreciation of their stock.
A valuation cap is a safety net in the event the company sees massive increase between seed funding and Series A rounds.
Like we talked about before, valuation caps are the only negotiating point necessary for SAFE Notes to be closed on. Valuation caps can also be combined with interest rates in convertible notes, to make sure the investor is paid, and the interest rate is low.
Focus on the war, not the battles
The equity of your business is a long-term project. Knowing how to manage it goes a long way at the negotiating table.
Negotiations can be tiring, especially when dealing with a large group of investors. It is perfectly fine for you to take your fundraising at the pace that’s right for your startup.
Now you are armed with the basics of negotiating the terms of fundraising for your startup.
