Three Methods of Fundraising: Which One Requires A Valuation?
By Lior Ronen | Founder, Finro Financial Consulting
Thinking about whether you need a startup valuation to collect funds for your early-stage venture? Well, it's not always a must. Let's get into the nitty-gritty.
Picture this: you've got a fantastic idea for a fresh startup.
To jump-start your dream, you'll need some funds – perhaps for getting hold of crucial software, hiring a freelancer, or shouting about your brand-new product from the digital rooftops.
Typically, budding entrepreneurs either raid their savings or grab small loans for this starter cash.
But once your idea starts taking shape, you’ll need a bigger cash injection. Maybe it's time to build an expert team to develop your product.
That's going to take more dough than just the initial bits and bobs.
Now, you hit a fork in the road. Do you cough up these costs from your own pocket, or do you seek outside investors? Each option has its unique twists and turns.
Digging deep into your own pocket (aka bootstrapping) isn’t doable for all. So, many startup founders go after external funding to bring their vision to life.
If you're splurging your own money, you're the boss.
Want to pour your budget into Instagram ads, or hire a first-class developer for half a year? No problem, because it’s your cash and your startup. No questions asked.
But if you're splashing someone else's cash, they'll want to know how it's being used and whether they'll get a return on their investment.
As a founder seeking investors, you've got three main paths: SAFE agreement, convertible debt, or equity. We’re sidelining bank loans in this chat, as they usually don’t ask for a valuation.
Ready to dive deeper? Let’s get started.
Founders raising funds for early-stage startups can choose among SAFE agreements, convertible debt, and equity financing. SAFE agreements and convertible debt allow deferred valuation, making early funding simpler; SAFE provides future equity, while convertible debt includes interest and converts to equity in later rounds. Equity financing, however, requires an upfront valuation and offers immediate ownership to investors. Each method has pros and cons, so the best choice depends on the startup’s growth stage, goals, and investor needs.
A SAFE Agreement: Breaking It Down
SAFE stands for "Simple Agreement for Future Equity".
It's a type of investment contract developed by Y Combinator, a well-known startup accelerator, to simplify the process for early-stage startups seeking initial funding.
A SAFE agreement allows investors to provide a startup with capital in exchange for the right to receive equity in the future.
The conversion to equity usually occurs during the startup's next funding round or at a liquidity event, such as an acquisition or an IPO.
But here's the key: this agreement doesn't specify a set valuation at the time of the initial investment. Instead, it includes a mechanism for determining the price per share and the number of shares the investor will receive in the future.
Mechanics of a SAFE Agreement:
Investment: An investor provides funding to a startup. In return, they receive a SAFE agreement, promising them future equity.
Valuation Cap and/or Discount Rate: The SAFE agreement usually includes a valuation cap and/or a discount rate. The valuation cap is the maximum company valuation at which the SAFE will convert into equity. The discount rate gives the SAFE holder the right to convert their investment into equity at a price lower than what's offered to investors in the next funding round.
Trigger Event: The SAFE converts into equity when a trigger event occurs. This is usually the startup's next round of funding (where new investors buy equity at a set price) or a liquidity event such as an acquisition or an IPO.
Equity Conversion: At the trigger event, the SAFE investor's cash converts into equity. The number of shares they get depends on the lower of the valuation cap or the discount rate (if these terms were included in the agreement), compared to the price per share in the trigger event.
A SAFE agreement can be an efficient, uncomplicated tool for securing early-stage investment. However, the lack of a fixed valuation at the time of the initial investment can lead to uncertainty. It's essential to seek legal and financial advice to fully understand how a SAFE agreement could impact your startup's future.
Why startups don't need a valuation when raising with a SAFE?
The beauty of SAFE agreements lies in their flexibility and the simplicity they offer to early-stage startups.
Unlike traditional fundraising methods, SAFE agreements don't require a company valuation at the time of the initial investment. Here's why:
1. Future Equity: SAFE stands for Simple Agreement for Future Equity. The key word here is 'future.' With SAFE agreements, investors provide capital with the understanding they'll receive equity at a later date, usually at the next funding round or at a liquidity event. This eliminates the need for an immediate valuation.
2. Valuation Cap and/or Discount Rate: A SAFE agreement typically includes a valuation cap, a maximum company valuation at which the SAFE converts into equity, and/or a discount rate, which gives the SAFE holder the right to convert their investment into equity at a lower price than the next round investors. This provides some protection for investors without requiring an immediate fixed valuation.
3. Avoiding Complex Negotiations: Early-stage startups often have a difficult time setting an exact valuation due to limited financial history and uncertain future prospects. SAFE agreements sidestep the need for these complex, often subjective, valuations. This simplicity makes SAFE agreements a quick and efficient fundraising tool.
4. Buffer for Startups: As a startup, your value can rapidly increase as your business grows and evolves. Locking in a valuation too early can be limiting and might undervalue your company's potential. By deferring the valuation, a SAFE allows the startup more time to demonstrate its value and potential to investors.
Now that we've explored SAFE agreements in detail, let's switch gears and delve into another popular method of fundraising for startups - Convertible Debt. This mechanism also delays valuation but does so in a different way. Let's discover how.
| Benefits | Drawbacks |
|---|---|
| Simplicity: SAFE agreements are more straightforward and easier to understand than traditional convertible notes. | Uncertainty: The lack of a set valuation or conversion price can lead to confusion and uncertainty for both investors and founders. |
| Flexibility: With no maturity date or interest, they provide entrepreneurs more leeway compared to traditional debt instruments. | Over-dilution:If not managed properly, SAFE agreements can lead to over-dilution of a startup's equity when these notes convert into shares. |
| Cost-effective: They typically require less legal work and fewer negotiations, reducing costs. | Potential Conflict:In the case of multiple SAFE agreements with different terms, conflicts can arise during equity conversion, leading to strained relations with investors. |
Convertible Debt Explained
Convertible debt, also known as a convertible note, is a type of investment mechanism frequently used in seed-stage or early-stage funding rounds.
Essentially, it is a loan made to a company by an investor (often an angel investor or venture capitalist) with the understanding that the loan will either be paid back or converted into equity at a later date.
When a startup raises money through a convertible note, it is saying, "We need funding now, but we'd prefer to agree on how much our company is worth (i.e., our valuation) later."
How the Mechanism Works:
Initial Investment: The investor loans a certain amount of money to the startup with the agreement that this loan will later be converted into shares of the company. At this stage, the money is technically a debt the company owes to the investor.
Interest: The loan usually accrues interest over time. However, instead of paying back the interest in cash, it increases the number of shares the investor gets when the note converts.
Trigger Event: The conversion from debt to equity usually happens during a subsequent funding round (typically a Series A round), when a startup raises money at a specific valuation. This event is known as a "trigger event."
Conversion to Equity: When the trigger event happens, the initial loan (plus any accrued interest) is converted into shares of the company. The conversion rate is usually influenced by the company's valuation and any specific terms agreed upon in the note (such as a discount rate or a valuation cap).
Discount Rate: To reward early investors for their risk, convertible notes often include a discount rate. This means the investor can convert their debt into equity at a price per share that is lower than the price per share paid by investors in the new funding round.
Valuation Cap: A valuation cap sets a limit on the valuation at which the debt converts into equity. If the company's valuation is higher than the cap at the next funding round, the note converts as if the company’s valuation were at the cap. This feature ensures that early investors get a larger percentage of the company.
Repayment: If the startup does not raise another round, the investor can choose to have their loan repaid with interest, or, depending on the terms of the note, they can convert the debt into equity at a negotiated valuation.
The Valuation Question: Why isn't it needed immediately with Convertible Debt?
One of the key advantages of convertible debt for startups is that it defers the valuation question to a later date, usually the next funding round. Here's why:
1. Investor Confidence: Convertible debt signifies the investor's confidence in the startup's future prospects. They are okay with deferring the valuation until the next funding round, when the startup has more traction and it's easier to establish an accurate valuation.
2. Flexibility: Convertible debt allows flexibility for the founders. They can negotiate the conversion terms, such as the valuation cap and the discount rate, which influence how the debt will convert into equity.
3. Time-Efficient: By deferring the valuation, startups can close funding rounds quickly, without getting into prolonged negotiations about the company's worth.
However, just like SAFE agreements, convertible debt comes with its complexities. Make sure to consult with legal and financial advisors before choosing this method.
Having explored Convertible Debt, let's move to the third fundraising method on our list: Equity. Equity is a bit more traditional, but it's still very much in use, and for a good reason. Let's see why.
| Benefits | Drawbacks |
|---|---|
| Quick and Efficient: Convertible notes can be a faster way to raise funds as they skip valuation negotiations, which can be lengthy and challenging. | Debt Obligations: Until the note converts, it's technically debt, and the startup is liable for it. |
| Interest Accrued: The money invested earns interest until it’s converted to equity, which benefits the investor. | Complex Terms: Convertible notes can include caps and discounts that might complicate the conversion process and cause disputes. |
| Deferred Valuation: This allows startups to avoid haggling over valuations at an early stage, providing time to increase their worth. | Risk of High Interest: The interest accrued could pile up if the debt doesn't convert quickly, leading to a larger equity giveaway. |
Equity Financing Explained
Equity financing is a method of raising capital for a business by selling a portion of its equity, or ownership shares, to investors. These investors could be individuals (known as angel investors), venture capital firms, or even the public, in the case of an Initial Public Offering (IPO).
The process of equity financing involves diluting the ownership of the original owners (usually the founders) in favor of external investors who provide the necessary capital to grow the business.
How the Mechanism Works:
Valuation: Before equity financing can take place, the company must be valued. This valuation is often a topic of negotiation between the founders and the potential investors, and can be influenced by many factors including the company's current revenue, its growth prospects, market conditions, and similar transactions in the industry.
Issue of Shares: Once a valuation has been agreed upon, the company issues new shares, or in some cases sells existing shares, equivalent to the amount of capital it wishes to raise. For example, if a company is valued at $1 million and it wishes to raise $250,000, it would sell a 25% stake in the company.
Investor Ownership: Investors who buy these shares become part owners of the company. The percentage of the company they own is equal to the fraction of the total shares they hold.
Use of Funds: The funds raised through equity financing can be used for a variety of purposes including hiring new staff, purchasing equipment, research and development, marketing, or expanding into new markets.
Investor Returns: Investors make money from equity financing when they sell their shares at a higher price than they paid for them, usually when the company is sold or goes public. In some cases, investors may also receive dividends, which are portions of the company's profits distributed to shareholders.
When it comes to equity financing, a startup's valuation is vital.
Valuation establishes the worth of your company at a specific point in time, and it's a key element that determines how much of your company an investor will own in exchange for their investment.
Establishing Ownership: For instance, let's say your startup is valued at $5 million. If an investor decides to invest $1 million, they are purchasing 20% of your company ($1 million / $5 million). In this case, your company's valuation determined the cost per share, and hence the ownership stake the investor received for their investment.
Fairness and Clarity: Valuation also helps in maintaining fairness and transparency between the founders and the investors. It gives a clear indication of the company's worth at the time of investment, helping to set expectations and preventing misunderstandings down the line.
Future Fundraising: Lastly, valuation sets the stage for future funding rounds. A high valuation in an early round can make your company more attractive to future investors, though it does also increase the pressure for your company to meet higher performance expectations.
Therefore, in equity financing, valuation plays a pivotal role. Unlike SAFE agreements or convertible notes where valuation can be deferred, equity financing requires a solid understanding of your company's worth upfront, which can be challenging for early-stage startups.
This is why some startups opt for other methods like SAFE agreements or convertible notes for their initial fundraising, transitioning to traditional equity financing as their company matures and they can more confidently determine their valuation.
This highlights the importance of considering the stage, needs, and valuation clarity of your startup when choosing a funding method. In the next section, we will discuss the pros and cons of equity financing to help you make a more informed decision.
Comparing Fundraising Methods and The Need for Valuation
Now that we've explored SAFE agreements, convertible debt, and equity financing, let's do a quick comparison of these three methods and summarize when a valuation is necessary.
SAFE Agreements vs Convertible Debt vs Equity Financing:
SAFE agreements and convertible debt are both forms of convertible securities, meaning they can eventually be converted into equity.
These options often appeal to early-stage startups because they allow the founders to defer the valuation process until a later date, when the business is more established and its value is easier to determine.
SAFE Agreements: SAFE (Simple Agreement for Future Equity) is an agreement between a startup and an investor that provides rights to the investor for future equity in the company. This type of financing is typically faster and simpler than other methods, as it doesn't involve as many complex terms. However, it doesn't offer interest or a maturity date, which can be unfavorable for some investors.
Convertible Debt: Also known as a convertible note, this is a loan that can be converted into equity at a later date, usually during a subsequent funding round. This method offers interest to the investor and includes a maturity date, but can come with more complex terms than a SAFE agreement.
Equity Financing: This involves selling shares of your company in exchange for capital. Unlike SAFE agreements and convertible notes, this method requires a valuation of the company up front. While it involves giving up a portion of ownership, it also doesn't incur any debt.
When is a Valuation Needed?
The need for a valuation depends largely on the type of fundraising method a startup chooses:
SAFE Agreements: No immediate valuation is required, as the SAFE is converted into equity at a later date, typically at the next funding round when the company's valuation has been determined.
Convertible Debt: Similar to SAFE agreements, no immediate valuation is needed. The debt is converted into equity at the next funding round, using either a valuation cap or discount rate.
Equity Financing: A valuation is required upfront, as it determines how much of the company an investor will own in exchange for their investment.
Each of these fundraising methods serves different needs and situations for startups.
As an entrepreneur, it's crucial to understand the benefits and drawbacks of each, as well as the circumstances in which a company valuation is needed.
This will help you make the best decision for your startup's unique needs and goals.
Now that we've compared the three methods and discussed the importance of valuation, let's wrap up and bring everything together in our conclusion.
| SAFE Agreements | Convertible Debt | Equity Financing | |
|---|---|---|---|
| Immediate Valuation Needed | No | No | Yes |
| Debt Accrued | No | Yes | No |
| Investor Interest | No | Yes | Depends on Dividend Policy |
| Ownership Dilution | Deferred | Deferred | Immediate |
| Complexity | Low | Medium | High |
| Maturity Date | No | Yes | N/A |
| Investor Control | Typically None till Conversion | Typically None till Conversion | Depends on Terms of Investment |
Conclusion
Raising funds is a crucial part of a startup's journey, and the method you choose can greatly impact your company's future. While the decision can seem daunting, understanding the differences between SAFE agreements, convertible debt, and equity financing can help clarify the best approach for your startup.
Remember that SAFE agreements and convertible debt allow you to defer your valuation to a future date, offering an easier entry point for early-stage startups. However, these methods come with their own sets of pros and cons, and may not be suitable for every situation.
Equity financing, on the other hand, requires an upfront valuation and offers a more traditional route to funding. While it may be more complex, it provides a clear ownership structure and can be a good option if your company has a clear idea of its worth.
In the end, the "best" method is the one that aligns with your startup's stage of growth, future goals, and the preferences of your investors. It's not uncommon for startups to use a mix of these methods as they grow and evolve.
We hope this guide has shed some light on these three common methods of fundraising and their relation to startup valuation. Remember, it's always a good idea to seek legal and financial advice before making these critical decisions. Good luck with your fundraising journey!
Key Takeaways
SAFE Agreement Flexibility – SAFE agreements defer valuation, providing early-stage funding simplicity without immediate ownership changes.
Convertible Debt Structure – Convertible debt combines loan interest and future equity, with conversion triggered by later funding rounds.
Equity Financing Ownership – Equity financing requires upfront valuation, giving investors ownership immediately in exchange for funding.
Deferred Valuation Advantage – SAFE and convertible debt allow startups to delay valuation until more financial clarity emerges.
Choosing Funding Method – The optimal funding method aligns with a startup's growth stage, investor needs, and financial goals.
