One near-universal consideration when kickstarting and negotiating a fundraise is: ‘What is the optimal instrument for this round of funding?” By instrument, we don’t mean wind versus brass. We mean financial instrument, such as an equity or debt (or SAFE) contract.
The equity vs. debt decision has major implications for company economics and control, and rising popularity of the SAFE over the past decade has increased the need for careful comparison across common funding options.
In this blog post, we present potential tradeoffs of funding company growth via an equity round, convertible debt, or SAFE (Simple Agreement for Future Equity) note. First, this post describes these three options and the process to complete, defining distinctive terms and favorable characteristics. Then, this post poses questions for the early-stage startup executive to identify the most favorable financial instrument, given company context.
Equity (Priced Round)
Description + Process
A seminal moment in a startup’s lifecycle is closing a fundraising round where investors (institutional VCs, angels, or otherwise) take a stake in the company via equity investment. In this transaction, investors provide money for an ownership stake in the business. With ownership – often consisting of Preferred Shares – these investors are entitled to a number of shareholder rights. They can require approval for various major business decisions (e.g., liquidation or sale of the company), robust reporting on the current state of business operations, and more. Often, a lead investor in an equity round will take a seat on the company’s Board of Directors and participate in governance. We won’t get into all of the control dynamics here, but a startup executive should consider if their company is ready for a more formal board with Preferred Stock Directors and the increased processes that accompany board management.
In addition, because investors are directly receiving shares for an amount of money, this transaction requires an explicit share price for the Company. Valuation is only one of many legal terms to consider, but is often a gating factor for new and very early stage startups; it can be challenging for investors to value an idea, a proof of concept, or a founding team alone, and it may be more prudent to both sides to wait for company milestones before putting a valuation on the business (hence why this is referred to as a ‘priced’ round).
If one were to proceed with an equity round, company or lead investor counsel will draft a set of legal documents that formalizes the new ownership breakdown and enumerates the rights of any holders of stock. (These documents include a Certificate of Incorporation, Stock Purchase Agreement, Investors’ Rights Agreement, Voting Agreement, Right of First Refusal Agreement – and more depending on specific investor requirements and employment / founder agreements.) In short, there is significant documentation to review and agree upon; this is why ‘term sheets’ are used to summarize and negotiate the key terms of an equity round before moving to full docs. After drafting these legal documents, the lead investor, company, and other potential major investors may still spend multiple weeks reviewing and negotiating terms and conditions of this transaction. Upon agreement, investors wire money to the Company, receive stockholder Certificates and finalized legal packages, and more. Founders and/or common shareholders no longer own 100% of the business and company decision-making and voting is altered accordingly.
Key Terms
As mentioned, there are a number of terms to negotiate with equity investors – here are a few key terms to consider (not fully exhaustive) to conceptualize the rights of said investors.
Anti-dilution Provisions: Antidilution protection is the right for an investor to not be diluted extra in the case that a future fundraise occurs with a lower price per share.
Board of Directors: This term lays out the structure of the Company Board. Because board members have a significant degree of influence, this is a critical control term with long-term Company implications.
Dividends: Dividends are a sum of money paid regularly by a company to its shareholders out of its profits or reserves.
Drag Along Agreement: A Drag-Along Agreement states that if a certain contingency of Major Investors are compelled to sell, they can 'drag' the founders or smaller, minority investors along with this decision.
Information Rights: The Information Rights term defines what information an investor is legally entitled to receive and when. Typically, these rights are only reserved for 'Major Investors' (as defined in the legal documentation).
Liquidation Preference: Liquidation preference refers to how a certain investor, or class of investors, gets paid out before another.
Pay-to-Play Provision: The Pay-to-Play provision is a term that incents investors to participate in future financings by stating that they would lose rights otherwise.
Pro Rata Rights: Pro rata rights, also known as the Right of First Refusal, define an investor's rights to purchase shares in a future financing.
Protective Provisions: Protective Provisions are veto rights that investors have on certain actions proposed by the Company.
Valuation: Valuation refers to how much a Company is worth in the context of the fundraise.
As evidenced by these terms, there are elements of ownership inherent to this agreement with investors that are not negotiated or included for Debtholders.
Notes on Favorability
Raising equity capital from the right partner(s) can be favorable to debt in that it incents investment and business professionals to lean into your business success – providing guidance and governance to get the company to the next stage. While more costly than debt, an equity round is also a helpful market validation of a startup’s value – especially if this is valuation is being agreed to by a new, outside investor. While not necessary, this does provide a useful data point for future potential investors or acquirers. Additionally, an equity round may be a helpful ‘reset’ for companies that have significant outstanding notes (convertible debt or SAFEs) or may require right-sizing of the existing valuation to incent new capital and incentives for new management. New equity investment may also be helpful in driving new debt investment or introducing / maintaining favorable terms with lenders (e.g., an equity ‘cure’ for tripped bank covenants).
Convertible Debt
Description + Process
Convertible debt (or a convertible note) is a type of bond that allows a holder to convert note principal and any accrued interest into a specified number of shares of Preferred or Common stock under certain conditions. This is a hybrid security with debt and equity-like features, but is considered debt and sits above equity in a company’s capital stack.
With convertible debt issuance, the lender (e.g., an investor) is not placing a firm valuation on the company and does not technically hold any ownership in the company. Also like debt, these noteholders require interest be attached to the principal (or investment amount) of their loan. (An interest rate is often in the range of 5-10%.) Investors, however, do typically require an incentive for investing between priced rounds (or at a very early stage) – either through setting a ‘Valuation cap’ or ceiling on their investment, requiring a discount in share price during the next priced round, or both (in which case the term that results in the lowest price per share for that investor is used). Convertible notes anticipate their investment amount and any interest converting into shares of the company at the next priced round or ‘Qualified Financing’ (as it’s defined in the note). Otherwise, notes could be redeemed, voluntarily converted into shares at a dictated share price (e.g., price of the last round), or paid out (e.g., 2x return) upon company sale.
A convertible note process is typically shorter than that of an equity investment and is reflected by two documents – 1) a Note (that is dated and lists the specific noteholder, with their specific investment amount – there can be many of these if there are many investors), and 2) a governing Note Purchase Agreement (or Bridge Note Purchase Agreement) that also includes closing conditions and reps and warranties of the company (essentially guarantees made by the Company to the Purchasers of the Notes). These two documents are often fairly short and can be drafted and approved fairly quickly.
Key Terms
Just like equity holders, convertible noteholders also have certain rights they specify in the note – largely dictating conversion from debt into equity.
Discount Rate: Discount rate is one of the main ways in which noteholders require upside for increased risk (investing early and not in a priced round).
Interest: As a debt instrument, a Convertible Note will often include an Interest Rate attached to the principal of the loan.
Maturity Date: This is the term, or length, of the loan. A convertible note is a form of debt that comes due at a specified point in time.
Most Favored Nations: This term provides the Noteholder with the assurance that no other convertible debtholder will receive more preferential terms than them.
Sale of the Company: This term states what happens to a noteholder’s investment if the debt is outstanding when the Company is sold – how they get paid out or how their investment gets converted into shares of the acquirer (e.g., in a stock-for-stock deal).
Valuation Cap: A valuation cap (or ‘cap’) is another way in which noteholders compensate for increased risk of investing early. This term puts a ceiling on the conversion price of the Noteholder principal and interest.
As mentioned, these are largely debt-like terms combined with conversion-specific terms.
Notes on Favorability
Convertible debt can be favorable due to the relatively quick nature of drafting and negotiating these terms (which makes the process less expensive). This instrument eliminates the need to explicitly value the company, pushing that responsibility to future investors. (The word ‘explicit’ is included here because a valuation cap is an implicit signal for the next valuation round target.) Because no price is dictated, a convertible note may be advantageous to startup executives who believe their company will materially increase in value in the near or medium-term.
SAFE Notes
Description + Process
A SAFE (Simple Agreement for Future Equity) note is a legally-binding contract between an investor and a company that allows an investor to purchase a specified number of company shares at a future point in time (e.g., next priced round). SAFEs are similar to convertible notes in that principal can convert into equity, and many SAFE notes will include valuation cap, discount rate, or Most Favored Nations clauses.
However, SAFE notes are different from convertible notes in that that are not a debt instrument (they are functionally like warrants, but without a pre-determined share price, or a variable prepaid forward contract). SAFE notes don’t have maturity dates or interest rates that require more complex cap table pro forma calculations. This may be disadvantageous to investors, as technically SAFEs can be held in perpetuity if a startup does not raise more money. Additionally, SAFEs may have lower liquidation priority than convertible debt (often, SAFEs are junior to payment of debt and treated on par with or paid out pari passu with any Preferred Stock), so investor return could be lower.
Key Terms
SAFE notes can include many of the same terms as a convertible note (alongside a Purchase Agreement). As mentioned, this includes the Valuation Cap, Discount Rate, and Most Favored Nations clauses. The SAFE also may state Liquidation Preference (which would also be specified with Convertible Notes if outstanding debt already exists) and specifics around a Cash Out / Liquidity Amount entitled at time of company sale.
Notes on Favorability
SAFEs are an innovation of Y Combinator and have become increasingly popular over the past decade due to the simplicity of terms and the relatively founder-friendly aspects of the instrument. SAFE issuance is typically quick and an increasing number of investors will accept SAFEs as an investment option. That said, balance sheet (equity vs. debt) and tax treatment of SAFEs is inconsistent and it may be wise to consult tax experts upon SAFE issuance.
Bull/Bear & Equity vs. Debt
While an equity investment represents direct and immediate ownership, convertible debt and SAFEs represent options for investors to take equity at a future time. Convertible debt theoretically holds option value for the investor (though in practice this is limited by redemption rights and/or mandatory conversion) and is both a low-cost entry point for an investor and a riskier early-stage proposition (given the uncertainty of future fundraise prospects). Investors have different approaches and Equity vs. Convertible Note vs. SAFE is a notable consideration when making new investments – many investors are interested in getting in as early as possible and having a foothold for the next priced round, while others may be reticent to come into a new company on a note. (They could opt to wait for the next priced round instead.)
Overall, however, equity versus convertible debt decisions by founders and investors are about making a fundamental bet on the company’s valuation now versus in the near to medium-term. This could be based on thoughts about company traction, broader market conditions, or a number of other things. From an economic perspective, both parties must consider ownership stake and dilution risk. At the highest, most generalized level:
Founders who believe the company is Undervalued (based on the fundraising market, forward-looking projections, etc.) will opt for Convertible Debt issuance
Founders who believe the company is Appropriately Valued or Overvalued will opt for Equity issuance
Investors who believe the company is Undervalued will opt for Equity issuance
Investors who believe the company is Overvalued will opt for Convertible Debt issuance, suggest a valuation reset, or choose not to invest
Again, this is an economic simplification based on the idea of dilution and perspective of present versus expected future value. Convertible or SAFEs, as mentioned, may be preferable in the case of high variance of valuation expectations. And prior fundraising context, company maturity, cap table dynamics, existing vs. new investor dynamics, capital requirements, cash burn, and exit timeline are all significant factors driving the equity / debt decision, as well.
10 Illustrative Equity vs. Convertible Debt vs. SAFE Questions
Given this context, here are ten questions an early-stage founder should ask themselves when considering the type of instrument to leverage as a source for growth:
How much do you think you can realistically raise in the necessary timeframe?
How soon do you need to close the deal / get money in the bank?
How bullish / bearish are you on the valuation you expect to receive? How will this impact your ownership? Current investor ownership?
When do you plan on raising next? What do you expect to accomplish between this fundraise and the next fundraise? How might that impact valuation?
How much money can you expect to receive from your existing investors or insiders, now and in the future? Based on this, is your cap table overly concentrated or disparate?
What is your board of directors saying? How about your closest advisors and mentors? How do you feel about these advisors and investors as long-term partners?
How might governance change upon new equity investment?
What is your existing capital stack? How much existing debt or liquidation preference overhang exists, and does this necessitate debt conversion or company recapitalization now or in the near future?
What is your company’s leverage ratio and/or what are the financial covenants, if any?
What is your expected exit timeline? Is it likely in the next year or two, or more like 5-10 years?
Summary
In summary, there are numerous tradeoffs involved when seeking funding – deciding which financial instrument makes most sense to your company is one of them. Often, impartial investors or start-up / VC mentors will be good thought partners and will be able to steer you in the right direction.
In the meantime, below is a summary table that reflects some of the pros and cons of the three options presented. This table is not exhaustive and bullets are not weighted equally in importance (this is very situational).
If you’ve made it this far – thank you for reading. If you are interested in reviewing a more comprehensive list and explanations of legal terms, legal documents, and/or pro forma cap tables to model implications of your fundraise on your company ownership, sign up for a free trial of Ridge today.