Financing Options: Convertible Debt and Safe

19.01.2016 |

Episode #4 of the course “A guide to seed fundraising” by Geoff Ralston, Y Combinator

 

Startup founders must understand the basic concepts behind venture financing. It would be nice if this was all very simple and could be explained in a single paragraph. Unfortunately, as with most legal matters, that’s not possible. Here is a very high level summary, but it is worth your time to read more about the details and pros and cons of various types of financing and, importantly, the key terms of such deals that you need to be aware of, from preferences to option pools. The articles below are a decent start.

Venture Hacks / Babk Nivi: Should I Raise Debt or Equity
Fred Wilson: Financing Options
Mark Suster on Convertible Debt, Announcing the Safe

Venture financing usually takes place in “rounds,” which have traditionally had names and a specific order. First comes a seed round, then a Series A, then a Series B, then a Series C, and so on to acquisition or IPO. None of these rounds are required and, for example, sometimes companies will start with a Series A financing (almost always an “equity round” as defined below). Recall that we are focusing here exclusively on seed, that very first venture round.

Most seed rounds, at least in Silicon Valley, are now structured as either convertible debt or simple agreements for future equity (safes). Some early rounds are still done with equity, but in Silicon Valley they are now the exception.

 

Convertible Debt

Convertible debt is a loan an investor makes to a company using an instrument called a convertible note. That loan will have a principal amount (the amount of the investment), an interest rate (usually a minimum rate of 2% or so), and a maturity date (when the principal and interest must be repaid). The intention of this note is that it converts to equity (thus, “convertible”) when the company does an equity financing.

These notes will also usually have a “Cap” or “Target Valuation” and / or a discount. A Cap is the maximum effective valuation that the owner of the note will pay, regardless of the valuation of the round in which the note converts. The effect of the cap is that convertible note investors usually pay a lower price per share compared to other investors in the equity round. Similarly, a discount defines a lower effective valuation via a percentage off the round valuation. Investors see these as their seed “premium” and both of these terms are negotiable.

Convertible debt may be called at maturity, at which time it must be repaid with earned interest, although investors are often willing to extend the maturity dates on notes.

 

Safe

Convertible debt has been almost completely replaced by the safe at YC and Imagine K12. A safe acts like convertible debt without the interest rate, maturity, and repayment requirement. The negotiable terms of a safe will almost always be simply the amount, the cap, and the discount, if any.

There is a bit more complexity to any convertible security, and much of that is driven by what happens when conversion occurs. I strongly encourage you to read the safe primer, which is available on YC’s site. The primer has several examples of what happens when a safe converts, which go a long way toward explaining how both convertible debt and safes work in practice.

 

Recommended book

“The Intelligent Investor” by Benjamin Graham

 

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