This is a companion to my post on sources of financing for your startup.
First, a quick review of Financing 101: All capital going into a company is either debt or equity. Debt is paid back over time, and the debt holder has no claim to ownership of the company or any future profits. Equity, on the other hand, doesn’t have to be paid back (they bought equity, they didn’t loan you money), but the equity holder is now a part owner of the company and has a claim to a share of all future profits. There are pros and cons to debt and equity — generally debt is considered “cheaper” but is more difficult for early-stage organizations to obtain. Also, debt is always senior to equity in the case of liquidation (debt holders get their money before any distribution to equity holders).
Any financing where the investor is buying part of the company in return for the capital. The investor now has a claim to a percentage of all future profits of the company, and to a share of any future sale (or liquidation of the company). The ownership share of an equity investor is always `New Capital / (Pre-money Valuation + New Capital) So, for example, if we agree that Pre-money Valuation of the company is $2M, and the investor is putting in $1M, then the investor now owns 33.3% of the company (1/(2+1)). Simple math — the hard part with an early-stage company is agreeing on what the pre-money valuation should be.
When an equity financing is done (see above), the investor may get equity that has certain preferential rights. The typical example is venture capital financing where the investor receives Preferred Stock, while employees hold Common Stock, and the Preferred Stock is senior to Common Stock in the case of liquidation of the company (ie, the investors get their money first before any distribution to employees and other common stock holders. See my separate post on Venture Capital Financing Mechanics.
Revenue Sharing Note
Structured as debt, with the repayment defined as a percentage of the company’s revenue. So, for example, it might be a $100,000 loan, repaid as 2% of the company’s revenue for 48 months, capped at 1.5x the loan amount. This can be especially well-suited to seasonal businesses, which generate more cash in some parts of the year than others.
A common investment structure for seed-stage financings, a convertible note starts as debt and then converts to equity upon some future trigger. A common scenario is to make is a 24-month promissory note, with interest accruing but no payments required, with conversion to equity at the company’s next equity financing. So, let’s say the company does a convertible note with an investor, and a year later the company does an equity financing with a venture capital firm. The note then automatically converts to equity at face value plus all accrued interest, at the same valuation as the venture capital firm has agreed to in the round.
Developed by Y-combinator as an alternative to Convertible Notes, a SAFE financing (Simple Agreement for Future Equity). The principle difference from a convertible note is the a SAFE financing is not a loan, it is more like a warrant (gives the investor the rights to purchase shares in the future) but without pre-determined pricing on that shares. See more information from Y Combinator.
With both Convertible Notes and SAFE’s, the entrepreneur and investor are agreeing that the investment will convert to equity at an undetermined valuation in the future. In the case of a crazy-high valuation, the investor may feel this is unfair. Let’s say I put $1M into a very early stage company and then two years later a VC firm says they’ll do an equity round at $100M valuation. This means that my money will convert to 1% of the company and I’m going to scream bloody murder — I put a million dollars in when it was a high-risk early-stage deal, I should be more than 1%!! Putting a Valuation Cap into the Convertible Note or SAFE solves this problem. If we agree on a Valuation Cap of $10M, then I know I’ll own at least 10% of the company, even if there is some crazy-high valuation at the time that my money converts to equity.
Warrants are an instrument that gives the right (but not the obligation) to buy stock at a certain price for a certain amount of time. The price at which the stock can be bought is called the exercise price or strike price.