Startups require the necessary capital and financing to help bring their ideas to fruition and gain market share. Founders face a dilemma of determining the types of investment vehicles that will help:
- Fund operations
- Attract investors
- Position the company for success
- Protect the founders
Choosing the right investment vehicle, whether it’s a SAFE, preferred stock, or convertible note, is one of the earliest decisions to make in financing. Often, the choice of investment vehicle is driven by the size of the financing and the company’s stage of development. It may also be driven by investor preference.
Lack of funding, or capital, is why 38% of startups fail. Investment vehicles help startups raise capital to fund operations, and each type has its own level of:
- Risk
- Return
You do not want your startup to start off with funding that requires excessive fees or that is not in the business’s best interest. Certain types of investment vehicles may not be appropriate for the size of the round.
Any financing involves the company giving up something to the investors in exchange for the money. The “something” is initially the investment vehicle, and ultimately, equity in the startup. Throughout a startup’s lifecycle, it’s possible to leverage multiple investment vehicles to keep operations running and to reach growth goals.
If you don’t know the investment vehicles open to you and how they can impact your company, it’s hard to know which one is the right fit for you.
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Convertible Notes
You may notice an overlap in convertible notes and SAFEs because they both convert to equity in the future, but the two are very different. In particular, a convertible note is considered debt, so it comes with:
- Interest rates
- Maturity date
Upon conversion, the note will convert at a discount or based on a valuation cap, much in the same way as SAFEs. Interest is typically accrued and then converted into equity when the note converts. So, if the note doesn’t convert for a long time, it is a benefit to the investor by increasing the number of shares the investor will get.
Because convertible notes are loans, they do have an adverse effect on the startup’s balance sheet.
If the startup reaches the maturity date before the note converts, the startup will either need to negotiate an extension of the maturity date, or find a way to repay the note.
Over the past few years, as investors outside of Silicon Valley have become more comfortable with SAFEs, convertible notes are used far less frequently.
Preferred Stock
If you need in excess of $1-2 million in funding, you will likely be using preferred stock in one of its forms. This type of a round is often called a “priced round,” because you are issuing equity in the company, and that equity needs a price.
Investors often prefer these types of equity because investors receive enhanced terms such as:
- Dividend payments
- Liquidation preference
- Anti-dilution protection
- Investor protections
- Right of first refusal and co-sale rights
What defines “preferred” will change from financing to financing, so it’s important to work with a lawyer who can help you clearly dictate what the preferred stock offers to investors. This will take place before and during the term sheet negotiations. The specific terms of the preferred stock are partly driven by whether you are issuing “series seed preferred,” used in smaller rounds of $1 million to $3 million, or series A (and so forth), used in larger financings. Think of series seed preferred like “diet Series A” – it will have a limited array of preferential rights, compared to the Series A.
Any preferred stock financing will be more involved, and the legal costs will be significantly higher than with a SAFE or convertible note financing. This is one reason why using preferred stock for any financing under $1 million to $2 million is generally inappropriate.
Preferred Stock
If you need to raise $1 million or more, preferred stock is an attractive option. Legal fees are often higher than the other options on our list. Investors receive greater rights with preferred stock, so it’s important to work closely with your attorney to negotiate what the terms of the financing will be.
Not sure what types of investment vehicles are in your startup’s best interest or want legal help to make sure that the agreement is in your best interest?
Kinetic Law can help.
We’ll draft agreements for financing and funding your startup to give you peace of mind that your business’s best interests are put first.
Contact us to discuss your business’s financing and funding needs.
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