Raising capital is often critical to business growth, but founders of startups may have a harder time securing funding, especially during seed rounds.
Fortunately, there are solutions that cater to founders while still appealing to investors. Two common fundraising options for early-stage companies are convertible instruments and priced rounds.
What is a convertible instrument?
A convertible instrument is a type of investment that lets founders raise money while postponing negotiations on the company’s valuation until a later time. Many founders turn to convertibles because they’re typically faster, cheaper, and more flexible than raising money via a priced round.
Here’s how convertible instruments work: An investor who sees potential in your business gives you money, and in exchange, they receive an instrument that can convert into equity in your company at a later date, usually in conjunction with the next priced round. In some instances, like in the case of a liquidity event, the investor could receive a cash payout instead of equity. There are two common types of convertible instruments: notes and SAFEs.
A convertible note is debt that can convert into equity upon a future qualifying event or transaction, like a priced equity round of $1 million or more.
SAFE stands for Simple Agreement for Future Equity. SAFEs convert into stock in a future priced round. They’re considered a type of warrant—not a debt—meaning they give investors certain equity rights.
How do convertible notes work?
Convertible notes often include a valuation cap and/or conversion discount.
- A valuation cap sets a maximum valuation—for purposes of determining the price per share—at which an investor’s money converts into equity, even if investors in the priced round agree to and pay a different price per share based on a higher valuation.
- A conversion discount gives investors a discount on the price per share—compared to other investors buying shares in the same priced round—when their convertible note converts into equity.
These features are designed to reward early investors who’ve taken a bigger risk with a better price than investors who come in later. If a convertible note has both a valuation cap and conversion discount, the investor typically gets to take advantage of the option that gives them the lowest conversion price per share.
As debt instruments, convertible notes also come with a maturity date and fixed interest rate. The maturity date is when the note expires. If the note hasn’t already converted into equity by the maturity date, the company is required to repay the noteholder’s principal investment plus interest. However, if both parties want to extend the maturity date, they can amend the note. Until the note either converts into equity or is repaid by the company, the note will accrue interest (usually anywhere between 2-8%).
How do SAFEs work?
Since SAFEs aren’t debt instruments, they have no maturity dates or interest rates, but they do typically come with a valuation cap and/or conversion discount. However, unlike convertible notes, which require the company to raise a certain amount of capital for equity conversion, SAFEs typically convert at any dollar amount the company raises during the next priced round.
Convertible instruments can be a good option for founders who need capital and want to fundraise quickly, but also want to reach certain company milestones before doing a priced round.
And though convertible notes and SAFEs are similar, SAFEs can be a better bet for founders who want to avoid maturity dates and accrued interest on investments.
What is a priced round?
Priced rounds are equity investments based on a negotiated valuation of a company. After agreeing on your company’s valuation, an investor gives you money in exchange for preferred stock in your company at a price per share determined by the valuation.
Preferred stock financings typically provide investors with liquidation priority payouts over other stockholders and other preferential features.
How do priced rounds work?
Priced rounds require more upfront accounting and negotiating than convertibles, but they also give you a clearer picture of how much your company is worth.
The price for preferred stock is based on what the company is worth at the time of the investment. Given that the price is set at the time of investment, investors get equity immediately.
Investors may also get more control rights in your company with a priced round, including voting rights, anti-dilution rights, and a potential seat on the board as a lead investor. Lead investors, or institutional leads, can serve as liaisons between you and other investors, acting on your behalf to drum up interest in the company and raise more capital. As a founder, you may get more money as a result of having an institutional lead, but you also have to cede more control to investors.
Priced rounds can be a good option for founders who are confident in what their company is worth, expect impressive growth, and need to raise a lot of capital.
Pros and cons of convertibles
Fast and affordable: Fewer terms to discuss means you spend less time negotiating and less money in legal fees.
Straightforward: You don’t need a lead investor to gather funding, nor do you have to give up control.
Valuations aren’t always necessary: If you’re not sure how your company will grow, you have the time to develop appropriate metrics to measure your company’s value for the next round of funding.
Enticing to investors: Investors may be willing to take a risk on your company because of the valuation cap and conversion discount that protects them.
Rolling closings: You can raise capital from several different investors over a period of time, instead of all at once.
Flexible: It’s fairly easy to amend the terms of the note.
Can dilute future rounds of funding: If you raise too much in convertibles, or if they convert at low valuations or with discounts, they can dilute your stock as a founder.
May still require valuations: If you decide to put a valuation cap on a convertible note or SAFE, you still end up having to agree upon some type of pre-money valuation, which can cancel out the benefit of deferring that valuation until a later date.
Can limit other investment opportunities: Without a clear lead to galvanize interest in your company, it may be difficult to secure other investments.
Pros and cons of priced rounds
Offers clear terms and certainty on dilution: It takes more time to negotiate the term sheet of a priced round, but detailed guidelines can help prevent misunderstandings and problems down the road. Plus, agreeing on a pre-money valuation gives you a better idea of how much company ownership you’re giving up.
Appeals to investors: Investors have more protection and rights with priced rounds, so they may be inclined to invest more money than they would with a convertible.
Generates interest: A lead investor can help create buzz around your company and raise even more money.
Requires more time: Not only do you have to agree upon a pre-money valuation, but you also have to negotiate your investors’ preferential rights.
Expensive: It costs more money in legal fees to set up a term sheet (guidelines) and negotiate definitive documents for a priced round.
Less autonomy: You may have to give a certain amount of control over to investors.
Fundraising for your growing business
If you need funding to grow your business, you can raise capital using convertible notes, SAFEs, or priced rounds. Priced rounds give you a better understanding of your company’s worth and division of ownership. Convertible notes and SAFEs, on the other hand, offer more flexibility and control if you’re still figuring out where your company is headed.
Growing a company is hard, but we’re here to make it easier. No matter what type of financing you’re starting with, Carta can help you get your cap table in order.
DISCLOSURE: This publication contains general information only and eShares, Inc. dba Carta, Inc. (“Carta”) is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein.