Early-Stage Financing Alternatives Demystified
One of the most common questions founders ask us is how to structure their next financing round.Typically, early-stage startup financing takes one of three forms – convertible preferred equity, convertible debt or an alternative instrument such as a simple agreement for future equity (SAFE). The structure appropriate for a startup depends on a number of variables, such as the stage of financing, the investor composition, the size of the raise, the particular terms being offered by investors and the timeframe available to the company.As a general rule of thumb, seed rounds (often defined as $750,000-$2,000,000 financing rounds) will be done through preferred stock while most smaller “friends and family” and angel rounds will use some form of convertible security, whether debt or an alternative instrument such as a SAFE.At all pre-Series A stages, understanding (and having counsel that understands) various financing instruments that are available, and their features, can be extremely important.In this article, we offer a very condensed summary of key advantages and disadvantages with each type of financing.
Convertible Preferred Equity
Raising a round of preferred stock is a traditional form of startup financing. Angel and venture capital investors generally like preferred stock because it typically provides favorable economic rights (such as a liquidation preference, dividends, anti-dilution protection against down rounds) and control rights (such as board representation, access to financial statements, right to consent to certain major decisions).From a founder’s perspective, the primary benefit of issuing preferred equity is that, unlike debt, there is no maturity date and hence no obligation that the investment be repaid. Preferred equity rounds are also priced or priced with a floor, which can give some certainty of valuation.However, particularly for a company in its early stages, valuations can be difficult to negotiate. On top of this, the parties’ negotiation of the parameters of the economic and control rights referred to above can prolong negotiations and add execution risk to the process. Closing on a preferred equity round also will place some more administrative burdens on the company as one of the main conditions to closing will be amending the company’s charter, which requires the company to obtain stockholder consents. However, if the company is at an early stage with a simple cap table, this may be more straightforward to obtain.
Convertible Debt
As an alternative, capital providers and founders sometimes seek to structure seed-stage investments as convertible debt, even though for founders it means offering their investors a more senior position in the company’s capital structure. Convertible notes are also often used to bridge two rounds of equity financing.An advantage of convertible debt is that a higher position in the capital structure and the forcing mechanism of a relatively near-term maturity can give investors greater comfort to forgo certain protections that are a typical feature of preferred stock (such as board seats). As a result, the documentation required to complete a convertible debt round can be simpler, with fewer terms to negotiate, resulting in lower legal fees and a faster timeline to close.In terms of downsides for founders, because a convertible note is a loan, it will either have to be repaid or, if the investor is willing, restructured at maturity if no conversion event has occurred. Often, investors will have significant negotiating leverage in those restructuring discussions because an early-stage company may lack the funds to make repayment leaving agreement with the investors the only alternative to avoid a forced sale or liquidation of the company. To avoid this scenario, founders will often attempt to include a mandatory conversion feature upon maturity. Investors will often resist such a provision as it can make the benefits of a convertible debt instrument illusory relative to a convertible preferred.Finally, in structuring a convertible debt instrument, founders and investors must engage in a valuation negotiation similar to that in a preferred round and a negotiation as to the terms of the conversion triggers.
SAFEs
In recent years, certain alternative instruments have been introduced to the startup financing landscape. Perhaps the most common of these is the SAFE. If simplicity is the goal, the SAFE can be an attractive option. It often postpones the valuation discussion and converts into equity based on the valuation in the next financing round (though often at the lower of a discount or a cap to the round’s valuation). Like equity, the SAFE does not have a maturity date so founders are not under the pressure of a looming maturity. Although investors frequently demand investor protections in a SAFE document, SAFE negotiations and implementation often occur more rapidly than that with convertible preferred or convertible debt.
Standardization
Finally, and favorably for reducing execution risk in start-up finance generally, there has been a trend towards standardized terms and open source documents, such as the Y Combinator SAFE and Series Seed preferred equity documents. While these documents do not always address all circumstances or key risks for investors or founders, they can be a very useful starting point.For more information regarding early-stage startup financing, please contact the Olshan attorney with whom you work regularly or one of the Olshan attorneys listed below.***Mitchell Raab is a Corporate partner at Olshan Frome Wolosky LLP who focuses on finance, M&A transactions, and general commercial counseling. Mitch routinely represents early-stage technology and growth companies, their investors and their major industrial partners in transactional and general commercial matters.Erik Syvertsen is Of Counsel at Olshan Frome Wolosky LLP and specializes in representing early-stage technology and growth companies on capital raising and transactional matters. Erik is also General Counsel to AngelList, where he is focused on fund product structuring, risk management, securities law and legal affairs.Honghui Yu is a Corporate associate at Olshan Frome Wolosky LLP who advises early-stage technology and growth companies on issues involving formation and financing and engages in general corporate and securities law transactions.