How many startups have a CFO as a co-founder? My guess is as good as yours! For most startups, the topmost early-stage priority is the product. It is only after the founders get it right, that they start worrying about funding it up. And even then, no CFO… just one of the co-founders starts wearing the second hat, learning the ropes on the fly.
Unlike mature companies, startups require flexible, innovative financing instruments that can accommodate the inherent uncertainty, growth potential, and valuation challenges. And therefore, the traditional capital stacks – structured hierarchies of debt and equity – do not work. So the last few decades saw the genesis of a Startup Capital Stack made of simple & preferred equity, convertible notes, mezzanine financing structures, etc.
Startups are also beginning to get access to Non-Dilutive Capital like grants & contest winnings sponsored by governments and corporations. Progressive governments are beginning to see the value in startups for the IP & employment opportunities they are able to generate. And, corporations, who have worried about startups being enemy giant killers, have started to lay out scouting infrastructure to sniff out the winning (and potentially dangerous ones). For startups, these grants & contests are newsworthy validations and a great source of capital they do not have to return.
Evolution of Non-Traditional Startup Capital Stack
Traditional startup financing models often fail to address startup-specific challenges such as:
- Valuation Uncertainty: Early-stage startups struggle to set fair valuations, making immediate equity issuance difficult.
- Cash Flow Constraints: Startups rarely have predictable cash flows to service debt, limiting traditional debt use.
- Complex Negotiations: Equity rounds can be time-consuming and costly, delaying critical funding.
- Dilution Concerns: Founders want to minimize ownership dilution while securing growth capital.
These have led to startups seeking other non-traditional options like Crowdfunding, Peer-to-Peer (P2P) Lending, Crowdlending and Revenue-Based Financing for revenue generating startups. Of these, crowdfunding has created some popular successes including BrewDog (raised £126 million), Pebble Time ($20 million), Oculus VR (raised $2.4 million, acquired by Facebook for $2 billion) and Monzo (£20 million raised). These non-traditional options seem to address the above failings but have some failings of their own… that’s another story.
The SAFE Bet
In 2013, Y-Combinator innovated Simple Agreements for Future Equity or SAFEs. Truly simple – no interest, no returning capital, no haggling over valuation – just a promise to convert to equity in future, when a valued round materializes. Because there is no haggling over valuation or immediate issuance of equity,
- It is easier and simpler to execute as it takes out the traditionally biggest bone of contention during negotiations – the valuation
- Since they are easy to negotiate, they are fast!
- Since it is not a loan, there is no interest, and no returning of capital.
- They offer reduced founder dilution because their conversion is computed based on subsequent valuation rounds, compared to the early rounds.
- They also align investor returns with startup success, incentivizing support beyond capital.
- They offer balance to the capital stack – supporting growth without overburdening the startup.
But not all is well with SAFEs. While investors and the startup settle into this marriage very easily and quickly, it may so happen that some of the contentious issues tend to get back-ended. Some of the things that could go wrong:
- Because there is no maturity date, investors could wait indefinitely without guaranteed conversion or repayment
- Multiple SAFEs upon conversion can cause unexpected and significant dilution for founders
- Different SAFE terms tend to complicate equity allocation and ownership clarity
- Lack of voting, information, and anti-dilution rights could deter some investors
- Misaligned fundraising incentives could arise from the founders’ desire to delay rounds and SAFE holders’ desire to convert early
- Since there is no guaranteed conversion, SAFEs may never convert if no priced round occurs
Conclusion
The startup capital stack is no longer a simple hierarchy of debt and equity. It is a dynamic, evolving structure that must adapt to the unique risks and opportunities of each growth stage. Understanding and mastering this new capital stack enables startups to secure the right capital at the right time, optimize ownership and control, and position themselves for long-term success. Instruments like SAFEs have revolutionized early-stage funding by offering simplicity, flexibility, and alignment of interests. All said, the startup capital stack should continue to evolve to navigate the challenges of present times!
