Part 2 of a series about raising funds for startups: Seed financing with convertible notes, Simple Agreements for Future Equity (SAFE) or preferred stock.
There are five rounds of fundraising in the economic growth of a startup. They are typically called the “family and friends” round, the seed round, and then the Series A, B and C rounds of security offerings. Prior posts have provided an overview of these rounds and an in-depth look at the family and friends round. This post covers the three most common seed financing investment vehicles and the legal documents required for each of them.
A Bit of Background
At this point in the life of a startup, the business is up and running, but the founders need seed financing to raise enough money to operate for a year or two in order to prove the viability of their product. One way to raise the necessary funds is to sell stock in the company, which previously has been incorporated, preferably in Delaware.
But raising capital by selling common stock for seed financing is not typical. An investment in any startup is risky. Investors therefore want more rights in the company than common stock provides. Further, if the company sells its stock, it has established a value for that stock. That value is usually is much higher than the value at which the company would like to offer stock to its employees by way of option grants or restricted stock. For that reason, the startup might not be able to attract the best talent if it sold common stock to raise funds.
The company must use an investment instrument that gives early investors more rights than they would have as common stockholders and avoids valuing the common stock. Startups and investors have created three widely used seed financing investment vehicles that meet these requirements. They are the convertible note, the simple agreement for future equity (SAFE) and the sale of preferred stock.
Convertible Notes for Seed Financing
Using a convertible note is the most common method for seed financing. It is a loan to the company that converts into equity upon the occurrence of a conversion event. The event usually is the issuance of a round of preferred stock although it could be the maturity date of the note. The conversion price is normally capped, either based on the value of the company upon conversion of the note or at a discounted price per share. The note usually carries little or no interest and is not secured although the noteholder does enjoy a preferential position should the company fail and be liquidated.
The lawyer’s job is to draft the convertible note. Ordinarily, the company and the investor will come to terms on the investment and write them up as a term sheet. After further communicating with the parties, the lawyer can memorialize their agreement in the note.
Simple Agreements for Future Equity (SAFE)
The SAFE was developed by Y Combinator in 2013. With a SAFE, an investor gives money to the startup in exchange for the right to convert that money into a proportion of equity. A SAFE investment itself is neither debt nor equity. No interest accrues, and there is no maturity date.
SAFEs vary depending on whether they contain a valuation cap and a discount. A valuation cap sets the maximum price at which the investment turns into equity. A discount entitles the investor to obtain equity at a discount.
Accordingly, there are four types of SAFE for seed financing:
- Valuation cap and discount
- Valuation cap but no discount
- No valuation cap but discount
- No valuation cap and no discount
The final SAFE — neither a valuation cap nor a discount — includes a “most favored nation” clause. What that means is that if the company issues a later SAFE containing terms better for the investor than the first SAFE, the investor is entitled to have the same terms as the second SAFE.
SAFEs are standalone legal instruments that are straightforward to prepare, although there are ancillary legal issues that the lawyer must address, such as the issue of taxation.
Seed Financing Using Preferred Stock
The third commonly used seed financing technique is to issue a round of preferred stock. Preferred stock can be attractive to investors because it gives investors more rights within the company than does common stock. Among these rights are:
- A preferential position should the company fail and liquidate
- Requiring preferred stockholder consent for important company decisions
- Preemptive rights
- Drag-along rights
- Possibly a seat on the company’s board of directors
Issuance of preferred stock for seed financing requires legal assistance not only for drafting the necessary legal documents but also to ensure compliance with the federal Securities Act of 1933 as well as any state securities laws (“blue sky” laws).
By default, the Securities Act requires registration of securities with the federal government. Registration is an expensive and time-consuming process. There are exemptions from registration that can save time and money. The two most commonly used exemptions for seed financing are the private placement exemption and the exemption permitting no more than thirty-five unaccredited investors.
There are three primary vehicles for seed financing: The convertible note, the SAFE and the issuance of preferred stock. Which technique would be best for a particular startup is best determined after consulting with counsel.
Image attribution: Francesco Gallarotti
Originally published at https://www.carpenterwellington.com on March 7, 2020.