If you’re a founder raising capital, you will at some point have to make the decision of which method you want to use for that investment. It can have a great influence on the future of your business, so you want to get this right!
Investors make multiple investments every year, so they usually know what they’re doing. Maybe you’re expecting the investor to make this choice for you. But it’s better if you as a founder know how the three different types of methods for financing work, so you can identify what’s best for you and your startup.
However, as a founder, you are probably doing this for the first time, so please let me explain how the three methods for financing work and how they can play out in the long term.
I’ll explain it in layman’s terms. If you’re a lawyer reading this, it might make you cringe. At the same time, I’m no lawyer — so before making a final decision, always check with yours.
A priced equity round is what everyone knows about. Before today, maybe it was the only method for investing that you knew existed.
An equity round means that the transaction is done and the investors directly buy and own a certain amount of the shares in your company.
Usually, it’s preceded by a term sheet, laying out most of the terms of the investment. If you accept those terms, a formal due diligence process with lawyers and accountants follows. You also need to spend some time aligning any potential co-investors that might want to join the round. After that, you and all the co-investors sign a Shareholder Agreement, and the capital is transferred to the company account.
As you can guess, this process is very rigid and can take a lot of time. You have to negotiate all terms upfront, which can be a daunting process. It can also get expensive as you need to include lawyers in the process.
In other words, this is what you want to do if you’re raising a larger round, typically of €1M or more. Then the process is worth the effort to get a solid agreement for the years of work that will follow with this investor.
On the other hand, if you’re raising a smaller round, like a $100-200k, then this process is such a waste of time. It can also be a waste of money. It’s not founder-friendly when you only have a team of 2-3 founders, who quickly need some cash to get their startup up and running. Time is money!
I once met a team that raised $120k but had to pay $10k in legal fees… yikes.
I’m sure you want to avoid that, so let’s talk about some alternatives.
The convertible note is debt financing, but which converts to equity at your next round of financing. This means that the investor transfers the capital right away without getting shares immediately. Instead, you have an outstanding loan to this investor until you’ve raised your next round or reach the maturity date.
There are not many terms to negotiate compared to the equity round. Mainly, you’ll need to set a valuation cap — not a valuation of your startup, per se. Rather, it should be set as an estimate of what your valuation is today.
You also have a discount rate. This is the discount this investor would get from your valuation when you raise if it is a lower valuation than the cap.
You will have to set a maturity date, which is the time that the debt becomes obligatory to pay back. This only happens if you haven’t raised an equity round before this date.
Since it’s debt financing, you need to negotiate the interest rate. You will need to pay the interest at the time of the conversion, even if it converts to equity.
The convertible note is a much faster method of financing than an equity round. There is less negotiation to do and you can sign a standard document.
For Europeans, it’s also an advantage that this method is available in all countries with different types of legislation.
However, there is one big drawback— that is debt. By raising a convertible note, you’ll add debt to your balance sheet until the conversion happens. Depending on the legislation this can create problems since you, as founders, can become personally liable to reimburse the loan.
These are issues that would only happen if things don’t go as planned, in case you don’t find investors for an equity round or your startup is not taking off as you hoped.
SAFE stands for Simple Agreement for Future Equity and was created in 2013 by Y Combinator in the US.
In some ways, it is similar to the convertible note, except that it’s not debt. Like the convertible note, you have a valuation cap and discount rate that you need to agree on with the investor. However, you have no interest rate.
The SAFE in the US typically doesn’t have a maturity date. In other words, this means that if you never raise an equity round, the investor will never get any shares in your company.
For most of the cases in Europe, however, this works very differently. Here, we often see a maturity date in the agreement, that is typically set for 2-4 years after the SAFE was signed. After that date, investors can opt to get their investment converted based on the fallback valuation (often called floor).
The fallback valuation is very important to negotiate. It should be at such a level that you would never give away more than 25 % in total to all investors that use a SAFE to invest.
Depending on the country, the SAFE note has different names in Europe. Here are some examples:
France: BSA Air
SAFE is a founder-friendly method of financing because it’s standardized and fast, without becoming a debt trap, but it’s not common on the European continent, yet. At the moment, it seems that only the most startup-savvy angels know about it and like it.
If you’re raising a couple hundred thousand dollars, I really recommend this method of financing.
With that said, you still need to watch out for some potential traps. As mentioned, be careful with the fallback valuation. If things don’t go as fast as planned, you don’t want to end up in a situation where investors get half of your company’s shares.
Also be careful to not add too many SAFE notes, since you might end up giving away much more equity than planned. Sit down, and do the calculations before signing.
If you get an offer for a SAFE note with an unusually high valuation cap and a big ticket investment, compared to the phase you’re actually in (check the benchmarks here), then I would opt for an equity round if possible. That way, you lock in that great deal.
Equity round, Convertible note, or SAFE note — they are all good for different things. It’s only by reading up and understanding their different characteristics that you can find out what’s best for your company!