Do you have an amazing startup idea, but not sure how to fund it? Have you heard about equity and convertible debt, but completely confused how they work and which one is a better fit?
In this article and the corresponding video, we introduce you to three main financing vehicles.
Equity represents company ownership. The process of determining how much equity to offer investors is fairly straightforward.
Step # 1. You value your company.
Step # 2. You determine how much money, or investment, you need.
Step # 3. The resulting investors’ equity stake is calculated as the investment amount over the company value. For example, if your company is valued at $10M and you are raising $1M, you will offer investors a 10% stake in your company.
While the steps themselves are easy, there is a catch - it is NOT easy to value an early stage company. As a result, the investors and founders may have vastly different ideas of how much a company is worth, which, of course, makes it very hard to agree on what equity stake investors should get.
To solve this problem, investors came up with two other financial vehicles which allow to delay a company valuation until a later point when more data is available.
Convertible debt is a debt instrument that converts to equity based on certain rules and upon occurrence of certain events, or triggers. You will have to value your company only when the conversion happens, but not before.
In the event of non-conversion, you MUST repay the outstanding principal together with accrued interest on the due date. You can also repay both at any time before the due date and before the debt converts.
Investors love this financial vehicle because it helps them mitigate risk in the event of non-conversion, or when the company is not doing well. For comparison, if they made their investment in the form of equity, they would simply lose their investment. Now, they can get it back PLUS interest.
This, of course, is not great news for startup founders. In fact, if not structured properly, this vehicle may cause a lot of problems for the company and even make it more difficult to raise money in the future.
Simple Agreement For Future Equity (SAFE)
This financial vehicle is similar to convertible debt, but without a debt component. It also converts to equity based on certain rules and upon occurrence of certain events, or triggers. Just like with convertible debt, you value your company only when the conversion happens, but not before.
However, when a SAFE does not convert, it simply remains outstanding, unless there is a provision that forces conversion after a certain period of time. We recommend this vehicle as opposed to convertible debt, precisely because it does not need to be repaid in the absence of a triggering event.
Read more at The Ultimate Guide to Angel Investing.
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