The 3 Ways to Fund Your Startup
For founders of early-stage companies, having a crystal-clear view of what you are building, but a cloudier picture of how to get there is a fairly common problem. You very likely may reach a point where you determine you need outside capital to reach important milestones in your business’ trajectory. And while there do exist a number of different ways to raise funds, the sheer number of options turn what would ideally be a fairly straightforward process — “you give me money and I give you equity or pay you back at a premium” — into a situation where you are forced to focus your attention on legal documents and number-crunching, when you’d probably rather be focused on hiring, sales, product, and…you get the picture.
Given the presumably lean nature of your team in the early days, you might find yourself forced to wear yet another hat within the enterprise, one with significant implications both today and potentially months and years down the road. For this reason, we recommend founders get familiar with the most common sources of funding, which when understood should make life easier if you do decide to venture down any of these paths of fundraising.
We attempt to simplify that hurdle in this post. Because while it might be overwhelming to consider at first, there is a common and even commoditized approach that can be followed to get you from MVP to IPO.
SAFEs
A SAFE (Simple Agreement for Future Equity) is a relatively simple method for raising funds in a venture’s nascency. This type of agreement was popularized by the venture accelerator Y Combinator and has since become a sort of standard for first financing rounds. A SAFE can simply be used as a means of selling future equity without all the complexity of a priced round, or they can be structured with discounts or valuation caps (more on these concepts below) that make the terms more attractive for these early investors (and more expensive for you). The terms you are offered will likely depend on the types of investors you are working with. Generally speaking, a SAFE is a simpler method of fundraising than a Convertible Note or equity raise given the relatively limited negotiable terms.
SAFEs are neither debt, nor equity, so they do not have a maturity date for principal repayment, and do not accrue interest. Instead, these agreements call for the conversion of the investor’s principal into equity in your business the next time you complete an equity investment, and at the same terms as your new investors negotiated. The relatively friendly structuring of SAFEs make them an especially common form of financing in Pre-Seed and Seed rounds. With a SAFE, your Uncle Harold (who’s only remotely related experience might have been “investing” in backyard improvements) can provide your company with a capital infusion without the need for a thorough valuation and without needing to coordinate terms and agreements with other investors.
Conversion Event: Your next priced equity raise.
Convertible Notes
Whereas a SAFE and a Convertible Note are similar in that they both convert into equity at later dates, there are a few key differences to be aware of.
Unlike SAFEs, Convertible Notes are in fact debt. This means they sit on your balance sheet as a liability and have maturity dates and accrue interest (though generally speaking this accrued portion would just be tacked onto the principal at the point at which the investment is converted to equity). Further, Valuation Caps and Discount Rates (which, as we noted, may or may not be included in SAFE), will almost always factor into Convertible Notes and will need to be agreed to by you and your investors.
A valuation cap rewards seed stage investors for the risk their early investment bears by providing a ceiling at which a Note will convert to equity. So, if your Series A investors invest at a $10M pre-money valuation, and a Convertible Note holder has a $5M valuation cap, the Note holder (to oversimplify) will effectively be issued twice as many shares relative to their initial investment.
A discount rate is another mechanism that may be included in a Convertible Note, further incentivizing early investment by ensuring that an investment today will be locked in at a better deal relative to later investors in a priced-equity round, even if the business’s value decreases. For example, a discount rate of 20% means that a Convertible Note holder’s investment will be converted to shares at a per-share price 20% less than new investors at the named conversion event.
Note holders with both a valuation cap and a discount rate will typically see their investment convert at whichever is more favorable to the investor.
The inclusion of these additional terms in Convertible Notes (versus their absence — most of the time — in SAFE agreements), along with the inclusion of explicit language around conversion-triggers provide meaningful protection to investors, which is why they are often times a good form of investment for your first rounds with institutional investors. Given that Convertible Notes are also more standard in form than an equity round, they are ultimately less expensive and can also be closed on a piecemeal basis with different Notes closing with different investors on their own timelines, as opposed to the need for everything to come together at the same time in an equity round.
Conversion Event: Usually your next equity raise, but ultimately dictated by the terms of the Convertible Note, which may also include minimum requirements for fundraises to protect issuers from dilution.
Priced-Equity
If your company has shown strong product-market fit, you may decide it is time for you to “go all-in” on an attempt to capitalize on your early traction. In order to accelerate growth and reach additional milestones on your product roadmap, you may find that it makes sense to bring industry-specific veterans onto your team, further invest in product, and generally improve the operational efficiency of your business.
While earlier fundraises are generally accomplished by the SAFEs and Convertible Notes discussed above, larger raises of this nature — those meant to provide a platform for your business to scale significantly and lay groundwork for operational improvements — are mostly accomplished by priced-equity rounds. That is not to say that priced equity never happens in earlier rounds, or that SAFEs and Convertible Notes cannot be utilized by founders to meet certain business needs when their company reaches a stage that we might customarily see a priced-equity round. Every situation is unique and depends on many different factors that you will need to think about when considering outside investment.
That said, a raise of this scale would typically come in the form of a priced-equity round, with the first instance of this generally referred to as a Series A, which might ultimately lead to B, C and so on. This would be the first time in which you are explicitly selling equity/ownership in your company to investors, rather than offering alternative structures that will eventually become equity (i.e., a SAFE or Convertible Note). Investors at this juncture will likely be of the more institutional variety rather than individuals, though angel investors can certainly join in a series round.
At the time of a Series A fundraise, your company is likely still pre-profit, but generating revenue, so investors will be typically be looking for you to use this money to continue growing to attract more investors in a Series B; a focal point of your conversations with potential investors will be how you plan to put the money you raise to use, with the expectation a lot of the time that you will be able to support at least an 18-month runway. Still, it is worth noting that the “standard” venture route many have come to expect has evolved; and you are not out of the game if your path doesn’t follow this trajectory.)
This also may be the first time your company will receive an unbiased valuation. As such, your financials will need to be in good order, you will need to have the right systems in place and be able to demonstrate regulatory compliance. All told, the team you have assembled, the company’s performance to-date, deal pipeline, product roadmap, and total addressable market will be the primary things that investors assess as you market the investment opportunity.
Diligence is not the only thing you need to be prepared for during a priced-equity round. In addition to all that goes into investors arriving at a pre-money valuation, there are several other important items that must be agreed to during a Series A negotiation: liquidation preferences, investment amounts, board appointments, vesting schedules, dividends, option pools, to name several, but likely not all of those items. The complexities of a priced-equity round do not end here; these rounds are generally filled by more than just a single investor. In addition to there being a lead investor that will set the terms of the investment, their commitment will likely hinge on your ability to bring on other follow-on investors to commit some amount less than the lead investment, but on the very same terms. And for the round to close all these pieces need to come together at the same time.
A priced-equity round will be a gamechanger for your company’s growth and have significant implications that shape the future for your company. Closing these rounds can be complex. The expertise required to adeptly execute a round like this does come at meaningful cost (both financial and emotional). Fortunately, by the time you reach this stage you, will likely have some finance-focused members on the team to share the load and lawyers to guide you through the process as well.
A Fourth Option You Shouldn’t Overlook
Early stage entrepreneurs often find themselves feeling pressured to build a “unicorn”. With this as a white-boarded goal, comes self-imposed pressure to grow at all costs, which might lead you to think you need to raise money as soon as you can. And while in certain situations this might make sense, it is not the only option in the playbook for you. Expectations like this often do more harm than good and can get in the way of building a strong positive cashflow business that does not need to rely on private investment. It is entirely possible for you to build an objectively successful business with a self-funded approach.
Bootstrapping, or simply not raising outside venture capital, might work for your business. Besides saving you money and equity, bootstrapping also naturally ensures you focus on the core of the business; building product and getting traction rather than getting distracted by newly available capital and perhaps attempting to do non-essential things along the way. If hardcore bootstrapping won’t cut it, you may be able to find other sources of financing. A traditional bank loan or public grants may be available to your business and would both fit into this fourth approach, as their costs are either nil or not tied to your growth, and will therefore be far less expensive in the long run. If you are in a business that does not require significant investment before a product can be brought to market, you might want to consider a slower and steadier approach.
Before You Sign
The opportunities that fundraising present early-stage founders are no doubt exciting, but you do trade away some of your upside when taking investors on too early, so it is vital to be thoughtful and forward-looking in your approach to fundraising. Blitz scaling, while impressive, does not ultimately guarantee long-term success. In all but the rarest of cases, a company’s ability to generate sustainable profits will be what markets judge it by, and profitability at scale, well that is what dreams are made of. Anything you can do in the early stages of your business’ operations to retain maximum ownership over these potential outcomes should not be lost sight of.
The fact is, you can always raise later, but you cannot recapture dilution. Waiting to raise allows you to have greater control of the terms of deals in the future, more so than would be possible if you raise earlier than you should. Furthermore, the process from SAFE to Convertible Note to priced-equity might seem formulaic and linear, in reality it’s not going to be a simple 1, 2, 3. All founders, companies, and investors are different, and your business can change dramatically between SAFE 1 and SAFE 2, let alone what might change before you even “graduate” from a SAFE.
It is a good idea for you to get familiar with SAFEs, Convertible Notes, and Priced-Equity rounds, as well as any other financing options that might be available. The bespoke nature of each type of financing means that some preparation ahead of time should go a long way. Given the significant implications that fundraising can have on the future of your business, we hope that this primer and our deeper dives into each type of financing are helpful in planning your approach to growth. Indeed, bootstrapping your business for as long as possible shouldn’t be overlooked as an option.
This article was written by Alex Mayo and can also be read here.