I’ve recently noticed an uptick in startup clients raising money for the first time. Sometimes sales are booming and money is needed for expansion, sometimes it’s a strategic investment by a larger player, and other times it’s early stage money used to get the company started. Whatever the reason, if you’re a founder looking to raise money, it’s important to understand the difference between the three most common types of fundraising offerings – equity, convertible debt, and SAFEs. Choosing the right vehicle for the investment is essential for ensuring the fundraise moves smoothly and without surprises. At their most basic level equity holders are owners, convertible debt holders are lenders, and SAFE holders are contractual parties. The format chosen and the terms offered may depend upon the stage of the company and leverage between the founder and the investor, and the choice may impact the company in different ways.
In a nutshell – equity is a fixed ownership stake in a company. For example, if you are buying the common stock of a publicly traded company through a brokerage account, you are buying equity. After you’ve made the purchase, based on the number of shares you own and the total number of shares outstanding, you would be able to calculate your ownership stake in the company. You would also be able to calculate the “market capitalization” of the company based upon the total number of shares outstanding and the market price of the shares – it would effectively tell you how much the total company is worth and how much your shares are worth.
For early-stage companies, issuing equity is often tricky because of both a lack of information and the cost of the documentation. First, many startups don’t have any true independent valuation of their business – at least for purposes of investment. Often the founders will assert that the company is worth multiples of what an investor might believe it to be worth. With this disconnect, it can be difficult, if not impossible, to fix the values necessary in order to sell equity to investors. Second, issuing equity requires a fair amount of paperwork to document, which increases the costs for the founders and time for review – and most startups are working on a very tight budget with limited bandwidth. For these reasons, founders usually don’t start their fundraising with a sale of equity to outside investors.
Convertible debt is essentially a loan to the company that is set to convert to equity upon the occurrence of certain events, often including the earlier of a fixed maturity date or the company’s next equity financing. The debt is documented with a convertible note that will contain an interest component, often a valuation cap (a maximum valuation of the company at the time of conversion), and sometimes a liquidation preference (the note holders get paid first in some circumstances).
Companies may prefer convertible debt to equity because it can delay the need to put a valuation on the company and often involves less negotiation and documentation than the sale of equity. A company that has dependable cash flow and leverage with investors may choose to issue convertible notes in which the loan terms, such as the interest rate or a buy-back provision, may favor the company.
One risk of convertible debt is that the debt holders could demand repayment of the debt upon maturity or another triggering event. If the company does not have the available cash to repay the debt, it could trigger a default. This risk is generally small, however, because the note holders usually want to have the company succeed in order to increase the value of their potential equity, rather than cause the company financial hardship.
SAFE stands for Simplified Agreement for Future Equity. A SAFE is a fairly recent addition to the methods by which a company can raise money. A SAFE is a contractual agreement by which the company agrees to grant equity to the SAFE holder upon the occurrence of the company’s next equity financing, whenever that may be. SAFEs often include a valuation cap or a “discount,” and sometimes both. These mechanisms allow for the early-stage SAFE purchaser to get a reduced price on later-issued equity.
For many founders, SAFEs are the preferred early-stage funding mechanism because they have the benefits of convertible debt – namely, they are easily documented and do not require the company and investor to agree on a valuation – without having a fixed maturity date or an interest component.
One risk for founders is that if they are not careful with the cap and discounts that are offered to the SAFE holders, they may find that they’ve sold a greater percentage of their company than they expected, with the investors receiving a windfall. Careful accounting with regard to SAFE sales is essential for the founders.
For a founder, it’s great to be in the position where investors believe in you and your company and want to give you money. More and more startups are using SAFEs for early fundraising, and given the ease of documentation and that a valuation is not needed, this trend is likely to continue. Established companies, or those that may wish to tightly control ownership percentages, may still opt for more traditional methods, such as equity. And some companies that have significant negotiating leverage and reliable cash flow may choose to issue convertible notes that have company-favorable terms. If you should find yourself in the position of an early capital raise, understanding the main methods of raising funds, and the benefits, risks, and costs of each, can help ensure that you choose the method best suited for your company.