Many startups will find themselves raising capital at multiple points. Fundraising can be challenging, and one of the more difficult aspects is understanding the various fundraising options available to business owners.
Two of the most popular fundraising methods are convertible notes and simple agreements for future equity, or SAFEs. Each of these options takes a different approach for raising funds to help your business grow, and neither requires a formal valuation. Rather, companies can set a valuation cap, which is essentially implied valuation and provides a buffer for setting a formal valuation.
Keep reading to learn which tool founders should consider for startup fundraising.
What Is a Convertible Note?
Simply put, a convertible note is a debt instrument that can later convert into equity. When the company receives subsequent funding, the holder of that note may (or sometimes must) proceed with the conversion. That conversion may come at a discount with subsequent financing and could result in complex conversion variations. Should the company fail to receive subsequent finding, the note holder has the right to be repaid under the terms of the instrument.
Convertible notes are a good way to close a seed round of funding, but poorly-structured convertible notes can result in long-term consequences. In fact, it can cost the founder a substantial chunk of hard-earned equity. Notes come with complicated clauses, they can negatively affect subsequent funding rounds, and investors may require payback if the startup fails. Liquidation overhang is more likely with this method, and attorneys are often involved in multiple steps of this process.
What Is a SAFE?
A SAFE is a type of instrument that facilitates a way for investors to provide pre-seed or seed funding to early-stage companies. SAFEs were introduced in 2013 by Y Combinator – a tech startup accelerator. Since their creation, SAFEs have been a popular option for founders looking to raise capital. Just a word of caution – despite its name, a SAFE in the hands of an uninformed founder is neither simple nor safe.
With a SAFE, investment lies in the startup’s potential value, putting additional risk on the startup and the investor if that potential value doesn’t actualize.
What Does a SAFE Do?
The goal of SAFE agreements is to streamline and accelerate the negotiations typically involved in the investment process. Thus, SAFEs present a set of standard, pre-agreed terms to govern an investment. A SAFE certifies that in exchange for an investment, the startup issues the investor the right to certain shares of the startup’s capital stock upon a specified future event like a capital raise or a sale of the business, subject to certain terms and conditions.
In straightforward terms, SAFEs allow for startups to raise funds quickly since there is no need to convince anyone of the company’s value. However, many SAFEs will project a future valuation for the protection of both the founders and the investors. When setting this valuation cap, founders should be wary of wavering equity conversions, potential equity dilutions, and decreased investor confidence, as these considerations will affect the determined cap amount.
Investors exchange a degree of uncertainty for the potential of a successful investment. SAFEs do not have a maturity date. Therefore, if the company never reaches a funding round, no repayment to the investor is required. SAFEs also do not accrue interest that will need to be repaid to the investor, and provide a degree of flexibility in the way the company raises capital.
Will My Startup Engage With These Fundraising Tools?
Both convertible notes and SAFEs are highly attractive tools for startups to raise capital. They each have their own built-in efficiencies as well as dangers. Some startups will issue both SAFEs and convertible notes, depending upon the goals of the investors and the outlook for future funding. However, more startups are opting for SAFEs, not only because they are more popular, but because they are also more standardized.
An Attorney Can Make Sure You Choose the Best Approach.
At HJF Law, our goal is to help startups launch their dreams into reality, and ensure founders are protected throughout the life of their business journey. We have drafted and edited many instruments of each fundraising nature, and we can do the same for your startup.
It’s never too early to hire a lawyer! Even if your startup is in the ideation phase, securing counsel now can prepare you for successful fundraising phases. Reach out to our team at (917) 726-8184 or contact us here for your free consultation.