You have finally secured your first paying customer, and your personal credit cards are officially maxed out. You have even passed around the hat and asked employees to forgo salary for a few weeks to help make a major revenue milestone. On the positive side, your startup is experiencing rapid growth, and several angel investors believe in the future of your team. It is time to raise capital to expand your business; however, you are not sure what type of investment will work best for your company. In this article, we will outline several of the different forms of equity you can choose in an angel investment round.
In an equity financing, often called a “priced round,” angel investors directly purchase capital stock from the company. This investment represents a defined percentage or fraction of the company and is based on the current valuation of the company. Generally, angel investors will purchase “preferred” shares of stock, which provide greater rights and privileges compared to “common” shares of stock. For example, if an investor bought 10 shares of a company worth $100, and the company had 100 shares outstanding after the financing, the angel investor would essentially own 10% of the company. Upon a liquidation or sale of the company, the angel investors would generally receive priority (after the company’s creditors) on their preferred shares before the founder’s shares of common stock.
A company might prefer an equity investment because the investment is not considered debt; therefore, the angel investors may not “call” the debt at an inconvenient time years later. However, the disadvantages of an equity investment are many – they require higher legal fees to negotiate, more documents to draft, and a wider range of terms to negotiate. Lastly, they lock in the company’s valuation at a very early stage in the company’s life cycle. If the company raises a Series A financing at a valuation less or about the same as the valuation at the angel investing round, it might trigger damaging legal provisions or signal to outside investors that the company is struggling financially. Typically, founders generally prefer equity rounds to avoid many of these disadvantages.
Convertible Debt Instruments
Convertible debt instruments serve as a useful alternative to equity investments. Convertible debt essentially allows investors to loan money in exchange for the future right to have the debt convert to shares of the company’s stock. The percentage and amount of shares that the debt will convert into is determined by the specific terms of the notes. Generally, the debt will convert to new shares offered in the company’s next equity financing. The convertible note also bears interest at a fixed rate, and the angel investors receive a liquidation priority before all of the company’s stockholders.
Companies often prefer convertible debt to equity financings because convertible debt can essentially delay the question of the company’s valuation until later in the company’s lifecycle. This provides the company more flexibility with later-stage financings. Convertible debt financings also involve fewer negotiation terms and less paperwork; this drives down both legal costs and deal timelines.
The main disadvantage of convertible debt is the nature of the debt itself; investors may call the debt after the maturity date or upon demand at any time. First, an early-stage startup will not have the cash on hand to repay investors if the debt is called. Secondly, companies should carefully evaluate the effect of valuation caps on convertible debt financings. A small cap will allow investors to receive a much higher percentage of the company upon an equity financing, and dilute common investors.
SAFE stands for Simple Agreement for Future Equity. SAFEs provide numerous benefits and are often the recommended investment structure, depending on the company’s specific situation. SAFEs serve as a placeholder for an equity investment in the company’s next equity financing. For startup founders, SAFEs are beneficial because they do not act like debt instrument – they do not accrue interest and do not have a maturity date. Like convertible notes, they do not require the company to adopt a valuation early on.
Generally, SAFEs lack many of the disadvantages of convertible promissory notes and equity financings. However, SAFEs with valuation caps, like convertible promissory notes, can lead to very dramatic gains for investors because there is essentially no upper threshold to what equity value SAFE investors might receive in the next round. For example, if a SAFE has a valuation cap on the next financing of $1,000,000, but the company actually raises a financing at $10,000,000, the investor will likely receive a massive windfall.
Often, the needs of both investors and the startup itself will determine the investment structure. A startup founder should weigh the advantages and disadvantages of the different forms of investments listed above, as well as consulting with experienced professionals. The consequences of choosing the wrong form could lead to serious problems later in the company’s lifecycle.