FinanceInvestment

What do you need to know about SAFEs, convertible notes, debt, and equity as a startup founder?

Startups in Africa have raised over $3 billion as of the end of the third quarter of 2021

The importance of funding for business growth and expansion can never be overstated as a business without access to funds will cave in under the burden of its debt. Funding helps businesses to set off with greater momentum in their desired direction. Most startups kickstart their ideas through Family/Friends/Founders (FFF) funding sources, and by bootstrapping operations.

However, the company can explore different avenues to getting access to funding, and more than one of these can be utilized. The chosen funding option will depend on the business’ desire to be in debt, the solvency of the business owners, and the amount of money a business will need to launch and maintain itself through a variety of events. In spite of all these, in interfacing with investors, a number of startups are oblivious of the different funding instruments that are available to them. This often paints these startups in poor light with regards to the knowledgeability of funding options and ways of synergizing with investors.

As a startup founder, you should be cognizant of the peculiar jargon that investors are wont to make use of in discussions with you on your business direction and the ways through which they can help you get to your desired destination.

Below is a list of types of investments that Startups can get:

Convertible notes

Convertible notes are a type of convertible debt instrument commonly used to fund early and seed-stage startups. Startups raise funding via convertible notes if they are not ready to establish valuation, but want an influx of cash before the next priced round of funding.

Convertible notes are usually issued with certain conditions like valuation cap (cap) or discount, which indicates what will happen when the amount of the loan converts into equity. These pre-defined measures may allow early investors to later purchase shares at a lower price than investors during that round, as an incentive to take a larger risk by investing early on. Valuation Cap sets the maximum valuation at which a convertible note investment can convert into equity.

The majority of convertible securities are issued with a cap. This is significant because the cap sets the value of the investor’s shares. If the valuation ends up being lower than the amount of the cap, the investment made via the convertible note will convert to equity at the amount of the priced round. However, if the valuation is higher than the cap, the investment made via convertible note will convert to the amount specified by the cap. In this latter case, the investor is rewarded for their earlier bet on the startup.

A simple agreement for future equity (SAFE)

A SAFE is an agreement that can be used between a company and an investor; the investors invest money in the company using a SAFE. In exchange for the money, with a SAFE, the investor receives the right to purchase stock in a future equity round (when one occurs) subject to certain parameters set in advance in the SAFE. The SAFE converts to equity at a later round of financing but only if a particular triggering event (outlined in the agreement) takes place. 

SAFEs are similar to convertible notes in that they both provide equity to the investor during a future preferred stock round and can include valuation caps or discounts.  Unlike convertible notes, however, SAFEs do not accrue interest and do not have a specific maturity date.

Debt

Debt funding for Startups refers to the variety of ways that a new business may be lent capital for it to get out of the startup phase and flourish. There are various debt funding options for Startups, they include;

Venture debt funding

Venture debt funding is a type of debt funding tailored for equity-backed businesses that do not have the cash flow or assets required for traditional debt funding. This kind of funding tends to be structured as a combination of limited equity investment warrants and a loan. The loan term is usually three years along with warrants for stock in the company. If such funding is properly used, it can reduce dilution while accelerating a company’s growth at a limited cost.

When venture debt funding is misused or entered into under unfavorable circumstances, it can lessen a business’s flexibility or be an obstacle to future equity. Other negatives could include:

  • Financial covenants: A venture debt loan could be tied to a business’s accounts receivable or cash balance, which could be risky for a young company, as having much-needed loans recalled at that stage could be highly damaging.
  • Default clauses: A lender could insert language in the loan agreement to allow them to demand loan repayment if certain income requirements or growth metrics are not met. They could also demand loan repayment even due to events outside of the company’s control, such as the loss of another investor.
  • Back-end loaded deals: A venture debt loan might offer a lower interest rate in the early stages but then require larger payments later on, which could place a severe financial strain on a growing company.

Loans

Loans are a commonly used and well-known way of obtaining capital and can be an ideal way to get your business off the ground if you can get a loan on favorable terms. However, it can be a challenge, as new businesses are often seen as a high-risk investment, especially if you are a first-time business owner.

Revenue-based financing

Revenue-based financing involves a business agreeing to share a percentage of its future revenue in exchange for an investor’s capital upfront. The loan payments will be tied to monthly income, with more profitable months yielding higher loan payments. Thus, this type of financing can often yield an uneven cash flow in the early stages when revenue can vary widely. Several banks and lenders specialize in this kind of financing. The pros of this method include gaining financing without yielding control or equity; the cons of this method include higher effective interest rates than a traditional bank loan.

Equity financing

Equity is the percentage of a startup share that it is willing to sell to investors for a specific amount of money. As a company makes business progress, new investors are typically willing to pay a larger price per share in subsequent rounds of funding, as the startup has already demonstrated its potential for success.

Equity financing can be through an entrepreneur’s friends and family, investors, or an initial public offering (IPO). An initial public offering (IPO) refers to the registration and sale of stocks of a private firm or company to the general public. The primary purpose of the IPO is to generate operating capital for the company or to create liquidity by opening its stock for public trading on stock exchanges or in private (over-the-counter) transactions. When venture capital investors invest in a startup, they are putting down capital in exchange for a portion of ownership in the company and rights to its potential future profits. By doing so, investors are forming a partnership with the startups they choose to invest in. If the company turns a profit, investors make returns proportionate to their amount of equity in the startup and vice versa.

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