Convertible notes are... great.
But they are also a bit of a mess.
While investors in the US are very much accustomed to these fundraising vehicles, investors outside
the US are not, and I don't blame them.
It is a bit of a mess.
SAFEs take the premise of convertible notes and try to simplify the terms to make them
easier to grasp for founders, investors, and future investors.
People often forget about them; if your cap table is a mess today, with preferred shares
and weird exceptions, those are terms that prospective investors will need to understand
as well.
That means you diligently get more expenses and potential deal breakers
But to understand both convertible notes and SAFEs, you need to understand how startup
equity works, so let's get to it.
For that, we need to crunch some numbers.
We are used to hearing about percentage ownership, but that's not really how startup equity works.
When you establish a C-Corporation in the US (that's the most common type of legal structure,
and definitely the one investors want you to use), the company defines a finite number
of shares.
Let's use an example with a paper company that has two founders: Robert Dunder and Robert
Mifflin.
When Robert & Robert establish the company, they agree that they are going to be equal
partners, as most co-founders should.
(I made a video about how to split equity in the early stages).
So you'd check that out if you don't trust me 50/50 is the ideal.
Anyway, this, of course, means that each of them will get 50% of the company, but that
50% of the company is going to be represented in a number of shares.
A common approach here would be to establish the business with 10,000,000 shares of stock,
5,000,000 shares each—50%.
Those 5,000,000 shares of stock each founder owns are never changing.
They usually can't be sold or passed along to anyone unless the rest of the company approves
it, so for all sorts and purposes, assume that each one of them will always own 5,000,000
shares.
So when a new investor comes in, the founders don't give any of their shares.
Instead, the company will issue new shares of stock for the investor.
How many shares get issued determines the company valuation, so let's look at an example.
Let's say that Dunder and Mifflin agree to raise an initial round of $1,000,000.
Investors decide that they'd like 20% of the company in exchange for that money.
But where does that come from?
Why 20% and not 18%?
By saying that $1,000,000 equates to 20% of the company, we are also saying that the entire
company is worth $5,000,000.
The truth is that in the early stages of a tech startup, these percentages and valuations
depend mainly on the founder's bargaining power, how exciting the space is, how experienced
the team is, and how bullish the investors are.
I've seen founders waste hours trying to justify that valuation on a spreadsheet, and the reality
is that unless you have significant revenue (in the millions), estimating a valuation
for an early-stage company is fugazi.
I'll get back to this, but I'll show you how the transaction looks.
If founders and investors agree on 20%, that means that the post-money valuation of the
company was $5,000,000.
The pre-money valuation, in that case, would be $4,000,000.
The investors are effectively accepting that the company is worth $4M, and injecting an
additional $1M. Now, what happens with share distribution
is that the company will issue new shares for them to buy.
Again, founders are not going to be transferring their shares.
The company will issue 2,500,000 million shares of stock for Dwight.
This means that the new total number of shares is 12,500,000, of which 5,000,000 shares is
40%, and 2,500,000 is 20%.
The effective price per share for the investors is $0.40. ( 04 Screencap Financial)
It's critical that you understand this pre-money vs post-money valuation difference because
if you're not careful, you could get screwed over.
We made a whole video going into details about that.
OK, so now that we're clear about how issuing equity works, we can actually talk about convertible
notes and SAFEs.
The purpose of both of these fundraising vehicles is that they delay the conversation about
valuation.
As I said, valuations at the early stage are completely speculative, and some deals just
get caught up in that negotiation.
So let's cover Convertible Notes first- since they effectively were invented first, as far
back as the 1800s, crazy enough.
Anyway, what investors figured they could do to invest in a company without knowing
the valuation was structuring the investment as debt: a loan.
The intention of this loan is not pay back with interest but eventually converting into
stock.
At which valuation?
At whatever valuation, future investors agree on for the company.
This is one of the reasons convertible notes are also called Bridge Rounds because the
whole document structure is creating a bridge to a future round of funding.
So, just like any lean convertible notes have interest rates, and they have an expiration
date (which is called maturity date in these cases).
So taking this Dunder Mifflin example, let's assume that this investor comes via a convertible
note instead of an equity round.
They want to invest the same $1,000,000.
In this case, Dwight & the Roberts can't agree on the valuations so they decide to go with
a Convertible Note, so what they do is agreed on a Maturity Date (24months) after the investment
and then an interest rate for this investment/loan.
Usually between 2% and 7%.
Finally they agreed on a valuation cap and a discount rate.
But to get this we need to look at some charts again.
Ok, so let's say this investment happens, on a 5% interest rate and for now there's
no valuation cap or discount.
Dwight's investment doesn't convert, $1M it remains as a convertible note.
12 months later a new super investor comes in.
He is super bullish on this paper company and wants to invest $10M on a $40M pre-money
valuation.
In this case, Dwight's investment of $1,000,000 has grown to $1,050,000 thanks to a 5% interest
rate over 12 months.
Dwight's investment converts at the same valuation as the new investor, so $40,000,000 pre-money.
In that case, his investment would convert to 262,500 shares.
The new investors convert to around 2,500,000 shares, and this is how the equity distribution
looks like:
So what happened here?
Dwight took a huge risk on an early company, but because a new and bullish investor came
in, he only received a tiny % of the company.
So this is a bad deal for him.
That's why all investors will always want to set a cap or a discount rate on any convertible
note or any SAFE.
The discount rate works by defining a discount on the valuation cap the future investor is
getting.
So in this case, Dwight could request a 20% discount on the future valuation.
This is the prize he gets for taking a risk earlier on when the company was riskier.
However, in that same scenario, that doesn't help Dwight too much.
With the discount, his valuation to convert is $32M instead of $40M, which still leaves
him with a 2.54% of the company- again, not a great upside for the risk he is taking.
That's where a cap could kick in.
Dwight and the Roberts could agree on a $10M cap.
That means that when a new investment comes in, Dwight's investment will convert at a
valuation of $10,000,000 (pre-money).
After Michael's transaction, that would leave Dwight with a much more reasonable 7.75 % of
shares.
Valuation caps and discounts are mostly there to protect investors from a massive spike
in the company's valuations in the future.
That doesn't mean that today when the convertible note happens that the company valuation today
is equal to the convertible note cap.
They just mean that they'd like protection against a higher valuation than that.
When the convertible note converts, it converts at the lowest of the cap vs the valuation,
minus the discount.
Ok, so this investment for Dwight doesn't look too bad, he received a fair amount of
shares in exchange for his investment but it still has its issues.
What if the company reaches the Maturity date and has not raised more money?
A common problem actually happened to us.
We made a whole video covering what happens to a company in those cases.
But the point is Convertible Notes have a lot of moving parts, and a lot of variables,
and they are not 'simple'.
And that's where SAFEs were invented.
The SAFE document is a pretty standard template that YC drafted and made public/free in 2013.
It is rather new, so many investors aren't accustomed to it yet.
Essentially a SAFE is a simpler convertible note that no longer operates like a loan,
so there is no interest and no maturity date.
Instead, it just recognizes the capital injection, defines a valuation cap OR a discount (one
of the two), and pretty much that's it.
Just like we explained with the Convertible Note, the SAFE investment converts into stock
on a future investment round, either at the price of that round vs the Cap (whichever
is lower) or at the price of that round minus a discount.
SAFEs are fantastic because they have been standardized, they don't require a lot of
legal fees (if any at all) and they fulfill the purpose of letting a company move on from
fundraising back to work, fundraising is a big distraction.
A SAFE is really just 5 pages long, most of the language is pretty straightforward, defining
actions in case the company goes out of business, gets acquired or goes public before any other
equity financing.
You can find templates for both convertible notes and SAFEs in Slidebean.
Again, you can also download a financing calculator to estimate how much dilution can occur with
future rounds of capital.
Remember, this is what we do all day, help companies navigate this stuff.
Our current count is at $260M raised with our pitch decks last year (just on the rounds we
knew about).
We can crawl the web for investors, help you keep logs with our CRM, and of course help
with their company stories and their pitch decks.
You can sign up for our platform at Slidebean.com and you get access to everything, literally
everything, for just $29/mo.
If you just count the $5K in AWS credits you can get, your money is paid times over not
to mention if we can help you raise capital.
We'll see you next week!