By Matthew Whitehead
Q: My early stage startup company is trying to raise money absent the availability of traditional financing options. What is our best option if we are not yet ready to sell equity in the company to outside investors?
In these circumstances, startups typically approach investors to engage in alternative financing arrangements that provide immediate cash infusions and allow the company to temporarily preserve both its capital structure along with whatever limited cash flow it may have. Such financing arrangements are commonly accomplished through a convertible note financing or a simple agreement for future equity (“SAFE”) investment instrument.
Convertible notes and SAFEs are both structured such that the investor invests in the company in exchange for the right to convert his investment into preferred stock in the company at some point in the future, either when a certain threshold of additional investments is met or a particular event occurs, such as a sale of the business. To induce the investor to agree to this arrangement, the company grants favorable conversion terms, typically at a price discounted from that of the later equity financing or in accordance with a discounted pre-negotiated valuation cap. Respectively referred to as the “discount” and “cap,” these terms greatly impact the value and quantity of the investor’s equity upon conversion and are inevitably two of the most heavily negotiated points of these instruments.
The primary difference between convertible notes and SAFEs is that the former are debt instruments subject to repayment, while the latter are exclusively deferred investments untethered to a specific maturity date. The convertible note converts the investment into equity only when the company raises a pre-negotiated amount of other investments or some other triggering event under the note occurs. If such an event never comes to pass, the investor is entitled to repayment of his investment at maturity, plus interest accrued over the term of the note. By contrast, SAFE investment instruments convert the investment into equity upon a subsequent financing, regardless of the aggregate amount. This of course makes conversion more likely but comes at the cost of repayment protection otherwise offered by a convertible note.
Despite all best efforts to streamline early stage financing, traps remain hidden for the unwary. It is important to consult with an attorney to ensure that the proposed arrangement contemplates the impact of the agreement on future investments and evaluates the applicability of relevant corporate and securities laws.
Matthew Whitehead can be reached at matthew.whitehead@mclane.com.
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