If you need to raise funds to get your company off the ground, you might be wondering where to start. Fundraising without an impressive reputation or proof of revenue can be challenging, but there are more options than ever for founders who need capital for their fledgling companies. Enter: convertible notes.
Before we dive into convertible notes, let’s go over a few key terms:
- Fundraising: The process of selling a portion of your business ownership in exchange for money from investors. Many startup founders fundraise instead of borrowing money from banks or third-party lenders via business loans.
- Equity: A type of ownership in a company. When founders take money from investors, they usually give the investors equity—which is a portion of ownership in the company—in return.
- Stock: A type of security investors receive as equity. Shares of stock are pieces of ownership in a company.
- Financing round: A fundraising event for a company. Each round has slightly different fundraising goals and parameters for the investors. The seed stage is the earliest round, followed by the Series A round, Series B round, then Series C round.
- Price per share: The cost to buy a single share of stock in a company.
What are convertible instruments?
A convertible instrument is a type of investment that can convert into equity at a later date. With a convertible instrument, an investor loans you, the business owner, money in exchange for the promise of equity in your company in the future. It’s essentially an IOU.
Convertible instruments are a great fundraising alternative to priced rounds which are equity investments based on valuations. A valuation is a formal report that determines the fair market value of your company’s stock. In a priced round, an investor gives you money in exchange for stock in your company at the price per share set in the valuation.
Conducting a valuation is a good way to see how much your company is worth, but it can also lock you into a price per share that you may not like. If you don’t want to put a price on your company stock quite yet, you can fundraise using a convertible instrument. Also, if you just started your company, it is likely too nascent for a proper valuation. Both of these are reasons why many startup founders like to use convertible instruments.
There are two types of convertible instruments:
- convertible notes, and
Using convertible notes to fundraise
A convertible note is a form of short-term debt that has the potential to turn into equity at a specific time, like during a certain financing round or transaction. Because convertible notes are less structured—and therefore riskier—than priced rounds, they come with a handful of terms designed to protect investors, including maturity dates, fixed interest rates, and valuation caps.
A maturity date is a note’s expiration date. Until the note expires or converts into equity, you have to pay interest (anywhere from two to eight percent) on the money you receive. If the maturity date arrives and the note still hasn’t converted into equity, you’ll have to pay your investor back in full plus interest.
Most convertible notes also come with a valuation cap or conversion discount. A valuation cap is the maximum valuation at which an investor’s money can turn into equity. The cap—which dictates the price per share of stock—essentially protects early investors from having to pay a higher price per share compared to investors who come in later.
A conversion discount has a similar purpose as a valuation cap: to incentivize investors to bet on your company early on. Unlike a valuation cap, a conversion discount doesn’t depend on a valuation; it simply gives investors a discount on the price per share when their note finally converts into equity.
Both valuation caps and conversion discounts give convertible noteholders the opportunity to buy their shares of stock at a cheaper rate than investors who join the company during a priced round (see the example further down).
Using a SAFE to fundraise
SAFE stands for Simple Agreement for Future Equity. Like a convertible note, a SAFE has the potential to convert into equity in the future. However, while notes convert into equity when your company raises a specific amount of money, SAFEs simply convert into equity during the next priced round.
SAFEs also come with valuation caps or conversion discounts, but they don’t have maturity dates or interest rates. As a founder, that means you don’t have to worry about paying interest on a SAFE, but you may have a harder time convincing investors to get on board without that specific protection.
How a valuation cap works
Understanding valuation caps can be tricky, so let’s look at an example of how one works:
Imagine you’re the founder of PowerGrowth, a new startup.
An investor named Erin sees potential in your company and wants to give you $500,000 during your seed round, which is the earliest stage of fundraising. In exchange for her investment, you issue Erin a SAFE, which means her money will convert into shares of stock during the next priced round. After reviewing your internal ownership distribution and negotiating with Erin, you set a valuation cap on her SAFE of $3 million.
A year and a half later, an investor named Thomas expresses interest in your company during the Series A round of financing, which is your first priced round. Your company valuation comes in at $5 million and the price per share of stock is $1 a share.
Erin’s SAFE is converting into equity during this round, so she gets the opportunity to purchase her shares of stock. However, because her valuation cap was set at $3 million, she can purchase the shares of stock as if the company valuation was also only $3 million.
$3 million / $5 million = $0.60
That means Erin can buy stock at $0.60 a share, instead of the $1 Thomas will have to pay because he invested when the company had a higher valuation.
What to consider when fundraising with convertible notes and SAFEs
Convertible notes and SAFEs are fast, flexible alternatives to priced rounds, but they’re not perfect fundraising solutions. Here are some pros and cons to consider:
Pros of convertible notes and SAFEs
- It’s easy to get started. There aren’t as many terms to negotiate with convertible notes and SAFEs, so you can generally issue them faster—and save money in legal fees.
- You have more flexibility. You can change the terms of your note or SAFE with minimal headaches. Plus, you can postpone a formal valuation until you’re ready.
- You can attract investors. If you offer a valuation cap or conversion discount on your note or SAFE, investors are more likely to get on board.
Cons of convertible notes and SAFEs
- It’s easy to over-dilute your shares. If you raise too much money with a convertible instrument, or if your note or SAFE converts at a low valuation or with a substantial discount, you’ll have less shares of stock as a founder. You also might have less equity to offer future investors, which could turn them off.
- Valuation caps can be complicated. Setting the right valuation cap is challenging. Not only do you have to conduct a pre-money valuation of your company (before the first round of financing) to set a cap, you also have to consider how much equity you want to save for future investors.
How to make a smart fundraising decision
When it comes to fundraising, the option that works best for you depends on your capital needs and goals. If you’re debating whether or not to use a convertible note or SAFE, try asking yourself the following questions to get clarity:
- What are my fundraising goals? Consider how much money you need to raise—and when. If you need funds as soon as possible, a convertible instrument could get you capital quickly.
- What milestones does the company need to reach? Think about what you need to do to set yourself up for future fundraising success and growth. Maybe you need enough capital to launch your first product by the end of the year, for example. Or perhaps you want time to grow your customer base. Clarifying your milestones will give you a better idea of your company’s path forward—and how fundraising plays into that.
- How much equity am I comfortable giving up? You’ll inevitably have to let go of a certain amount of equity when issuing notes or SAFEs, but you need to think carefully about how much you’re willing to part with. In addition to maintaining your personal shares as a founder, you also want to set aside enough equity to entice future investors to take a chance on your company. If you accept too much money in convertible instruments upfront, there may not be enough equity to go around as your company grows.
- When do I want to conduct a formal valuation? Consider your company’s trajectory. If you want to wait to see how your company grows before setting an official price per share, a convertible instrument gives you that freedom. However, if you want a clear idea of your company’s growth potential and ownership distribution, raising money via a priced round might be a better way to go.
If you’re just getting started with fundraising, convertible notes and SAFEs can help you get the capital you need to grow while still remaining flexible. Before you move forward, though, make sure you consult your business accountant and attorney for advice.