Every startup begins with an idea. The idea grows and changes. Eventually, clarity is achieved. At that point, unless the founders are independently wealthy, they must begin raising capital to turn their idea into a profitable business. This post outlines the stages of startup funding and examines the types of investment instruments most often used to fund startups.
The earliest point at which raising capital occurs is called pre-seed funding. Normally, pre-seed funding consists of money the founders might already have plus loans from friends and family. These loans can be informal hand-shake agreements, or they can be evidenced by promissory notes. Either way, at the pre-seed stage, funding is relatively informal.
Nevertheless, at this point, or soon afterward, the startup should organize, preferably as a corporation but possibly as a limited liability company (under certain circumstances). Sometimes, the founders determine that raising capital even in the pre-seed stage requires granting investors equity interests in the startup, but this more often occurs with seed-stage funding.
Seed-stage funding is money raised from outside investors. The founders normally raise seed-stage funds before the startup is ready to begin operations but has a detailed plan of how to proceed.
Two general types of outside investors offer seed-stage funding. They are the “angel” investor and the venture capitalist. An angel investor is a wealthy individual who seeks to invest in a startup in exchange for equity. Venture capitalists, in contrast, are firms that invest in many startups but also seek equity in return for investment. Either type of seed-stage funding can be a one-time method for raising capital to assist the startup in becoming operational. But sometimes there is a need for continuing funding.
Alternatives for Raising Capital
There are three primary ways that an angel investor or venture capitalist can invest in a startup. They are by a “priced round,” a convertible note, or a SAFE note.
A priced round is simply the sale of stock in a corporation for a set price. The corporation’s board of directors approves the issuance and sale of the stock at that price. Then, investors may buy the stock at the price the directors have set for its sale. Investors become equity holders in the corporation. Depending on the circumstances, investors may receive preferred stock or common stock. Preferred stockholders are repaid first from any remaining assets if the startup is not successful.
Convertible Notes for Raising Capital
A convertible note is an instrument that has features of both debt and equity securities. On the debt side, the investor lends the startup money. In exchange for the money, the startup gives the investor a convertible promissory note. The note can be secured, or non-secured, as the parties determine. It might or might not carry interest.
The loan is normally relatively short-term, usually until the startup decides upon raising capital by issuing its Series A round, or in other words, its first significant round of outside investment. At this point the equity feature of the convertible note is invoked. The investor has the right to be granted equity in the startup in exchange for the debt the startup owes to the investor. At that time, the investor may then “convert” the debt into shares of stock in the corporation, or in other words, equity.
Investors often prefer the use of convertible notes over priced rounds in the early stages of seed funding because it can be very difficult to value an interest in a startup. The use of convertible notes allows valuation of equity interests in startups at a later time, when an investor can more easily determine the startup’s value.
Another advantage of the convertible note when raising capital over simply purchasing shares of common stock arises if the startup does not succeed. When that happens, the investor enjoys a preferential status upon liquidation. In other words, the convertible note holder is entitled to be paid from any remaining assets before the holders of common shares of stock may attempt to recoup losses.
The SAFE Note
In 2013, Y Combinator, a San Francisco Bay Area startup fund, introduced a model, simplified convertible note called a SAFE (simple agreement for future equity) note. SAFE notes differ from convertible notes in that they do not accrue interest and they have no maturity dates. SAFE notes are short for legal documents, only five pages.
Because SAFE notes are standardized, the only issue for negotiation is the valuation cap. A valuation cap entitles SAFE note holders to convert their interests into equity in the startup at the lower of the valuation cap or the value of the equity in a later priced round. The lower the valuation cap, the greater likelihood that the investors will profit from the risk they took by investing in a startup.
A major advantage for the startup that uses SAFE notes when raising capital is that there is no maturity date for a SAFE note. Although SAFE notes can convert to equity during a round of financing, it is possible that a profitable startup could operate indefinitely without any right on the part of the investor to convert. On the other hand, an investor might find a SAFE note preferable to a convertible note because of a potential for higher profit or because of a priority status upon liquidation following business failure ahead of these who hold convertible notes.
There are two important cautions for the use of SAFE notes. First, the SAFE Note was designed for startups that are incorporated (see article on converting from a limited liability company to a C-Corporation). Fridman Law Firm drafts SAFE Notes for limited liability companies (LLCs), but they are not used as often. Second, conversion can result in the need for a valuation under Section 409A of the Internal Revenue Code, which applies to deferred compensation under nonqualified deferred compensation plans.
The Best Ways for Raising Capital
The need for raising capital varies depending on how far along a startup is in its lifetime. In its early days, a startup has relatively modest needs, for pre-seed funding. This money is used to clarify the idea for the startup, to formalize the idea into a business plan and to organize as a business entity, either a corporation or a limited liability company.
Seed funding follows, where the founders seek money to implement their idea to turn the startup into a viable company. The founders may simply decide to sell stock in the company. But given the unfortunate fact that most new businesses fail, investors typically want leveraged returns in exchange for the risks they take from raising capital. The convertible note and the SAFE note grant the investor those potentially greater returns while providing needed cash for the startup to continue its growth.
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