Advanced Venture Capital 2018 Ch 4: Choosing the Right Seed Financing Instrument by Becki DeGraw

TL;DR - SAFE, convertible notes, and preferred stocks are the three ways to fundraise with equity. Each has its own properties.

Helpfulness - 4

Topic Tags - VC funding, convertible notes, SAFE, equity, preferred stock

Questions answered:

  • What is a convertible note?
  • What is a SAFE?
  • What is the preferred stock?
  • What rights does each instrument have?
  • How do these three compare to each other?

Summary:

  • SAFE: a contract to buy preferred stocks in the future at a discounted price. The fasted instrument for funding. While outstanding, the SAFE’s owner has no special rights and privileges unless specially negotiated.
  • A SAFE, however, can be liquified to the principal investment amount.
  • Convertible note: Will show up as debt until converted, therefore it accrues interest rate and has a maturity date and events of default. Principle and accrued interest is later swapped for equity. While it is debt, investors have no special rights and privileges unless specially negotiated. When liquidized, it may come in the form of 1) cash (principal + interest), 2) equity worth the same amount as cash in 1), or cash amount in 1) + a premium (usually 50 - 200% of principle).
  • Amendments can be made by the one person who invested the most for the principle payment if agreed upon. Otherwise, everyone must make a decision. It is important to note, interest rate and principal amount cannot by one individual even if he is the lead investor.
  • Preferred stock: “requires amending the company’s certificate of incorporation and entering into documents to create the rights of the preferred stock,” it is also the slowest and most expensive instrument for funding. Will show up as preferred stock on the cap table. Ownership percentage is case by case and decided by both the investor and founder, so both parties will know how much their ownership will be diluted by. Liquidation: can be sold, will also be paid back before common shareholders in the case of bankruptcy. Series rounds often allow the investors to put a board member in the company. Preferred stock has a similar amendment process to the convertible note. Special rights and privileges can be negotiated for but pro-rata and information rights are standard. Other rights and privileges include “anti-dilution rights, registration rights, rights of first refusal, and co-sale over key holder shares.”