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Funding is often critical to a startup’s growth, but it can be hard to come by, especially during seed rounds. If it does, founders often have a difficult time figuring out the best way to raise capital. However, there are quite a few seed funding options for founders to choose from today, compared to a decade back.
Three standard deal options are convertible notes, SAFE notes (Simple Agreement for Future Equity), and equity-priced rounds. Here is how they play out:
- Convertible Notes
- Equity priced rounds
To start with, convertible notes (“C-Notes”) are a debt instrument. They have the right to be converted into equity under two specified conditions on the offering documents. First, when the startup hits an agreed-upon valuation, and the other is after a specified period (maturity date). They generally carry an interest rate that gets factored in during the conversion from debt to equity. There is usually an implicit understanding that these notes are not to be repaid. Still, note holders certainly have the right to ask for repayment if the maturity date is reached before the startup can raise another qualified financing round.
Use Case 1
Let’s assume that an investor purchases $10,000 of convertible notes at an interest rate of 8% Simple Interest. Let’s assume that 24 months later, qualified financing takes place where equity is divested at $4 a share. The investor’s C-notes are now worth $11,600 with interest. So, they would receive 2,900 shares.
Use Case 2
Convertible notes are also raised based on valuation caps. Let’s assume that the same investor has purchased $10,000 worth C-notes at an interest rate of 8% and a valuation cap of $4 M. During the qualified financing round 24 months later, let’s assume the company is valued at $8 M pre-money, with 2,000,000 shares and each share being valued at $4 per share (as before). The investor’s convertible notes are now worth $11,600 with interest. At $4 per share, they would have received 2,900 shares. However, since they invested at a cap of $4M, they will instead receive 5,800 shares or twice the amount.
Use Case 3
Convertible note financing might also come with a discount rate. Let’s assume the investor has purchased C-notes worth $10,000 at an interest rate of 8% and a discount provision of 20%. After 24 months, the investor’s C-notes are worth $11,600. The qualified financing round sees equity divested at $4 a share. The investor’s discount provision enables them to buy shares at $3.2. Now, the investor gets 3,625 shares (11,600/3.20) instead of 2,900 shares (11,600/4).
Investors who understand what’s included in their note purchase agreement and the convertible note will find the investing process a lot simpler.
A SAFE, or Simple Agreement for Future Equity, entitles the holder to shares in a startup, generally in the form of preferred stock, if and when the company is valued in the future. SAFEs carry no interest.
The instrument made its debut in 2013 when Y-Combinator was created and issued for the first time.
Additionally, there is no maturity date for these notes, which means investors will have to wait until the company is valued before they can convert their notes into equity.
Read more about SAFE in one of our blog posts dedicated exclusively to this topic.
Convertible Notes vs. SAFE
- Maturity date: C-notes generally have a maturity date, but SAFEs do not.
- Trigger point: C-notes generally trigger only when a qualifying financing round takes place. SAFEs can usually be converted when any amount is raised as equity.
- Interest rates: C-notes carry interest rates ranging from 2%-8%, while SAFE notes are similar to warrants and do not pay interest.
- Debt instrument: A C-note holder can technically elect to convert their note into equity or, if maturity date has been reached, to ask for their investment amount to be returned. A SAFE is not the same as a debt instrument and does not have these clauses.
- Discount rates: Both C-notes and SAFEs have discount rates, usually in the 15%-30% range.
- Nature of notes: A C-note, if drafted well, may give the founders more control of the company. A SAFE, by nature, is simplistic and very broad, which could lead to challenges down the road.
Equity Priced Rounds
When a VC (venture capitalist) invests in a company early on, they take the most risk: Market risk, competitor risk, financing risk, execution risk, technology risk, regulatory risk, and others. That is where equity-priced rounds come in. These are investment rounds where founders and investors negotiate the startup\’s value and agree on a number.
The VC invests capital into the startup in exchange for immediate ownership (equity), potential board seats, voting rights, and anti-dilution rights. This type of investment usually involves multiple rounds of negotiation and tends to be more expensive due to legal fees, drafting, due diligence, etc. The terms of the agreement in equity-priced rounds are clear and do not \”kick the can down the road\” as they do in convertible notes and SAFEs.
This type of funding is preferred by founders who believe they have achieved product-market fit, their company has a large Total Addressable Market (TAM), and consequently need to raise a funding round quickly.
Below is a comparison table between the three funding options for founders.
Convertible Note vs. SAFE vs. Equity
|Level of simplicity||More complex than SAFE notes but less than equity.||Simplest. Easiest to close.||Lots of paperwork. Most complicated of these three.|
|Maturity Date||Date in the future.||Usually no Maturity Date.||Not applicable here.|
|Fees and Admin expenses||More expensive than SAFE notes.||Cheapest.||Most expensive of all three options.|
|Discount rates||Generally, in the range of 5-30%.||Generally, in the range of 5-30%.||No discount.|
|Level of control||Founders can lose control if the investors demand their money back on the maturity date.||Offers the founder the most control.||Founders give up a certain level of control as per the terms of the written agreement.|
|Valuation cap||They generally come with a pre-money valuation cap.||The valuation cap is often post-money, although founders may offer pre-money valuation caps as well.||No valuation cap. Equity rounds are based on current valuation.|
|Trigger point||It can be triggered on the maturity date or future funding round.||Usually, when there is a future round of funding.||Triggered immediately.|
|Future Challenges||Can dilute future funding rounds||The absence of a lead investor may cause challenges in the future.||It helps with future funding rounds if you have a lead investor.|
What’s in it for investors?
Today, there are multiple options for people who want to make their money work for them. They can invest in stocks, bonds, and alternatives (venture capital and private equity) depending on their risk appetite and investing goals. Those who make early investments in new high-growth businesses – popularly called startups are called angel investors. However, before deciding to invest in startups (i.e.which funding round to support), one must understand the risks associated with angel investing. We covered these topics in detail in ‘Who should become an angel investor?’ earlier.
As an investor, once you have decided to enter the world of angel investing, finding high-quality and curated deal flow is a common roadblock. If you are looking to build your deal flow pipeline, we are hosting periodic webinars to introduce vetted seed, Series A, and Series B startups. If you want to stay on top of emerging technologies that will potentially impact humanity in the years and decades to come, these calls may be of interest to you.
Featured startups in the past are focused on solving critical business problems in computation, telecommunication, healthcare, transportation, and sustainability.