So you’ve gotten some appointments with investors, and you’re preparing to make your pitch. If you’re successful, what will their investment look like?
An early-stage investment is generally called either pre-seed or seed investment. The very first round is often pre-seed. It’s still an investment, but it’s so early, and the risk so high, that angel investors have different expectations than they would for a later investment. Startups often use pre-seed money for prototyping or making a first critical hire.
A business at the seed stage of investment is usually a little further along, but still building the product and go-to-market strategy. Both seed and pre-seed are still early enough that it may be difficult to put a valuation on the business. Later stages of investment that attract VC funds, such as Series A, require valuation. For Series A, you might have to offer 10-30% of the business for investment (learn more about growth and investment stages).
In this post, we’re going to focus on early-stage investments before Series A. The paperwork and terms vary, but two common options are a convertible note and a SAFE.
A convertible note is technically debt (that is, a loan). You receive X amount of dollars from your investor, and interest accrues on what you “owe.” Legally, it’s considered debt until it “converts” into equity—which may happen when you acquire another investor in your next raise, sooner, or even later.
A convertible note allows startups to raise money without a fixed valuation, which is helpful when the business is very early and its potential is largely hypothetical. However, a convertible note does require paperwork that defines the terms and conditions of that investment. It also has a maturity date (usually 18–36 months later, or when the next round of funding happens). Your debt also accrues interest (which typically gets paid back in increased equity later). For that reason, it’s to the founder’s advantage to convert the note into equity sooner rather than later—assuming that all goes well with your startup and that you’re ready and able to raise another round on or before that maturity date hits.
A convertible note is usually considered more investor-friendly than founder-friendly, but that’s in flux, as we’ll explain later. In response, Y Combinator developed another form of early-stage investment: the SAFE note.
A SAFE note is legally not considered debt. SAFE notes don’t have to define all the terms of a convertible note, so they’re faster, simpler, and easier to execute. There’s no loan or maturity date. They simply convert into equity at a subsequent priced round. They’re so simple, in fact, that you can download samples from Y Combinator. You don’t even need a lawyer. In addition, for companies that hope to secure SBIR/STTR investment from the federal government, a SAFE note is a better choice as the government won’t invest in companies with any kind of debt, even a convertible note.
You can read more about the differences between a convertible note and a SAFE note here and here, but over time, some of those differences have softened. For instance, it used to be that no SAFE note had an interest rate, but today, sometimes they do—and sometimes convertible notes don’t. At first glance, you might wonder why any founder would do anything other than a SAFE note. But do your homework and read the terms carefully.
Most importantly, be sure you understand the math behind the investment you’ll receive today and the equity you’ll be giving up in exchange later. Both SAFE and convertible notes usually define a valuation cap, which defines the maximum an investor will pay for equity in the future. After all, you’re giving away equity in your company, and the value of the company is not yet defined. So you need to make sure that the amount you’re giving to investors will be reasonable for both parties. Do. The. Math.
So when your company is so new, and its value is hard to determine, how is an investment quantified? If someone invests $100,000 today, what percentage of ownership do they have in the company in the future?
First, let’s review some key terms (see more term sheet details here).
- Term sheet or letter of intent: A non-binding agreement that sets out the basic terms of how much equity and control are being exchanged for how much cash
- Valuation: How much your company is worth. Valuation is set at each round of funding.
- Cap: The maximum valuation of equity for a convertible note or SAFE
- Discount: What percentage discount the investor will get on future shares (early investors often pay less per share than those investing in a later round) if a subsequent priced round is lower than the cap
- Interest: How much interest will accrue on the investment before it converts
- Liquidation preferences: Who gets paid first if the company is sold or goes bankrupt
- Cap table: The record of each investment made in a company and its terms
Before each round of investment, a valuation is set on your company. This is the “pre-money” valuation. After each round of investment, a “post-money” valuation is set, which is the sum of the pre-money valuation plus the investment. For example:
Pre-money valuation: $1,000,000
Post-money valuation: $1,075,000
The value of the investment, then, is its percentage of the post-money valuation:
$75,000/$1,075,000 = 7%
Some Sample Math
Let’s look at an example of a convertible note for a $300,000 investment with a 20% discount with no cap. Remember, the note “converts” at the next round of funding. So suppose our company later offers a Series A round. The pre-money valuation of the company for this round is $10,000,000, and the share price is $1.00.
The holder of the convertible note gets a 20% discount on that share price, so they pay $.80 per share:
They’ve already invested $300,000, which at $.80 per share purchases them 375,000 shares:
And since each share still has a value of $1.00, even though the investor has paid a discounted rate of $.80 for it, the value of their investment is now $375,000, for a return on investment of 1.25x:
Now: what if the convertible note had had a cap of $5,000,000? In our example, the pre-money valuation was $10,000,000. So now the cap share price would be $.50 (rather than $.80):
$5,000,000/$10,000,000 = $.50
That $300,000 investment, at $.50 a share, now purchases 600,000 shares:
And since each share is still valued at $1.00, the value of their investment is now $600,000, for a 2x return on the initial $300,000 investment! (If the convertible note had also included an interest rate, the figures would look even better still for the investor.)
Finally, what percentage equity does the investor own? It depends on how much is raised in the round and the post-money valuation. If the company raises $5,000,000, for example, the post-money valuation would be $15,000,000:
Pre-money valuation: $10,000,000
Post-money valuation: $15,000,000
So that $600,000 is now a 4% equity stake. (See more terms and examples.)
If all this math sounds confusing, study up! It’s too important to get wrong, and it’s likely that you’re going to need investment, and for that, you will have to give up some equity. So be sure, as you look for investors, that you not only seek out good financial terms, but also investors whose support, connections, and good business sense will help you grow your startup and be successful. Ideally, an investment is a win-win all around.