Entrepreneurs have many choices as they set out to raise their first round of funding. Time is money, and taking the wrong kind of money at the wrong time can be crippling. So can spending your time writing a blog, but, when in Rome.
Here is comprehensive overview of four common choices for an entrepreneur’s first round of funding: SAFE, Convertible Note, Equity and Bootstrapping. I guess you can speak with a lawyer-type to learn more, but this should be sufficient.
A SAFE (Simple Agreement for Future Equity) is a convertible security that is not debt. It was created by Y Combinator to simplify Seed investment. It acts as a warrant to purchase stock in a future priced round. Simple, and aptly named. Like naming a comedy blog about business the ComedySeller. Some will say it’s lazy. Others would have written an ending to this joke.
A SAFE is only five pages long. And since it is not debt, there is no interest rate and no maturity date. The only thing it does is allow investors the opportunity to convert into the next round. It converts whenever you raise any amount of equity, which gives entrepreneurs less control.
One workaround is by raising common stock from friends and family, which doesn’t trigger a conversion. So, with one easy step you can both bridge to the next round without conversion and test how much your loved ones truly believe your company is going to change the world.
If you are a good negotiator, you can finalize a SAFE without a valuation cap. Also, contrary to popular belief, you don’t have to offer a discount to the next round.
Even with these terms, founders can end up with more dilution of their ownership percentage than anticipated, like your $4 Gin & Tonic at the local “intern bar” that when you think about how much alcohol is in it, isn’t actually that good of a deal. Founders end up raising numerous successive mini equity rounds using the SAFE format or traditional convertible notes. And, the appeal of more capital often overtakes the little thought that goes into the potential impact of these notes on future valuation and therefore dilution implications.
If you raise a SAFE for the right reasons, it makes sense. It is quick, cheap and anything that comes out of Y Combinator is apparently gold. Don’t raise a SAFE to postpone pricing equity until your valuation is higher or to stall until you find a lead investor to price the round on more attractive terms.
A Convertible Note is debt and is structured similarly to a loan. Which means it has an interest rate and maturity date. These are more complex than a SAFE with how, when and if it converts. Convertible debt can carry an interest rate ranging from a 2% - 8% (most falling around 5%).
These notes allow you to convert into the current round of stock or a future financing. It is only triggered when a qualifying transaction takes place, which is set in the agreement or when both parties agree on the conversion. Once you reach the date of maturity, an entrepreneur can either pay back the principle plus interest (if the company has enough cash to do that), or convert the debt into equity.
This complexity may pose a threat to your company’s continued operations by creating cash flow pressures, like interest and principal payments that you may not be in a position to satisfy. They may also prevent your company from gaining future financing via a suddenly expanded capitalization table after a forced conversion.
Multiple series of notes, either SAFEs or Convertible Notes, can create dilution waterfalls and hamper future priced rounds, as large portions of the pie have already been carved out to founders, converted note holders and Series A investors. In these cases, the only valuations that makes sense for a Series B lead investor may force the Ringo Starr of fundraising rounds, the down round.
Equity deserves another few blog posts in itself. Unfortunately, equity isn’t always valued correctly. A priced equity round is an offering and sale of newly-created stock in your company at an agreed upon price per share. Once stock is sold, investors are part owners of your company. The decision to bring in part owners, and choosing where you and your significant other are going to dinner tonight, are big ones to make and shouldn’t be done lightly.
Priced equity rounds permanently alter the capitalization of the company by adding those new stockholders. Given this permanence and the inherent complexity, many deal documents are required for stock transactions, which is time consuming and expensive.
However, doing this work provides you with a more thorough view of your business and financial model, so you can have realistic valuation discussions with potential investors. It will enable you to lay out concrete near-term goals for your company and decide what financial resources are required to launch and scale.
The problem with raising money is that it typically doesn’t come for free. Raising money increases the risk profile of your company. If you are fortunate enough to be in a position where bootstrapping is a feasible option, there are many benefits that come with it.
Bootstrapping forces you to figure out how to make money earlier on, which means you are less likely to run into a cash-issue down the line. Without funding, you only deal with customers. And your employees I guess. That means no investors or board to report to and pretend to listen to. Having said that, there are many VCs who are quite helpful as you are looking to hire and scale your business.
And, once you reach a certain scale and are still bootstrapped, it can turn out to be a strong asset and a major component of your brand.
In summary, there are advantages to each initial funding strategy. All I am saying is do the math. Look at what happens to your cap table when the notes you raise actually convert into equity. If you keep kicking the can on setting a valuation on your business, you could end up pretty diluted, like Seed investors in Uber after their 18th round.
I am a 25 year-old venture capitalist and amateur stand-up comedian living in NYC.