Funding Contracts
Author: Liza Nilsson
29 August 2022
Funding is an integral part of growing a startup. Initially, entrepreneurs use their own resources. At the product development phase, friends and family may support them with additional resources, which also involves customer engagement.
Angel investors are usually the first unrelated investors in a business. Their investments are typically in the form of convertible notes, or simple agreement for future equity (SAFE). Both of these are equity-linked forms of funding. The alternative at this stage is investment for shares or equity. Later stage funding includes options such as: debt, revenue-based finance (RBF) and flexible venture capital (VC).
Central to all of these options, is an expectation of a return on investment. Most of these options tend to be linked to equity (i.e., who owns what shares in the company) in some way. With this in mind, we start this article with a brief explanation of equity before we proceed to discuss the other contract options.
Equity
Equity refers to the ownership of shares, or stock, that an individual (or an entity) has in a specific company.
How does it work?
Startup founders initially own all the shares in their own company. In exchange for funding, new shares are issued to the investors. The founders don’t sell or transfer their own existing shares.
Share value is based upon the company’s valuation. So, it’s reasonable to expect that a pre-requisite for any equity-based funding round is a company valuation. Although there are many different methods of calculating a company valuation, not all are applicable to every company. These typically involve quantifying the return and risk elements associated with the company. A triangulation across multiple valuation methods is generally a sound basis for establishing a company value.
Pros and cons
On a positive note, raising funding through equity creates greater alignment between the investor and founder(s). However, raising funding through equity dilutes a founder’s ownership of a business. It also introduces a new decision maker.
Furthermore, as new decision makers, investors generally aim to hold preferred shares, instead of ordinary shares. Considering both share classes, both have a range of rights attached to them. The difference could include aspects of voting rights and dividend policy.
Convertible notes
A convertible note is a loan (debt) which converts to equity at some point in the future. The conversion is typically triggered by a future funding round or a maturity date. At times, convertible notes may carry an interest rate which typically accumulates, instead of being distributed periodically. The notes typically include a discount rate, valuation cap, or both.
How does it work?
The investor provides the startup with cash up-front. It then sits on the balance sheet as a debt to begin with. Once the trigger event takes place, the loan converts to equity at the lower of the share price as determined by the discount or the valuation cap.
Should the note carry an interest component, the conversion amount would include the accumulated interest. Should there be an exit prior to the note converting to equity, a pre-determined return on investment value is applied.
Pros and cons
The advantages of a convertible note is that it fast-tracks negotiation and reduces legal expenses. It also pushes the valuation discussion down the road, which is often a sticky point in the negotiation process. Yet, investors are still not party to the shareholders agreement and often negotiate the inclusion of protective provisions to compensate for this.
SAFE Agreement
A SAFE is a newer development in funding contract alternatives. Popularised by Y Combinator with the intention of further simplifying the investment process. It may carry both a discount and valuation cap, as is the case with the convertible note.
However, it’s not a debt. And there is no maturity date and no is interest is charged. The typical SAFE agreement also excludes any protective provisions.
How does it work?
As with the convertible note, the investor provides the cash up front with the promise of future equity. The only trigger event for conversion, however, is the next round of funding. An exit prior to conversion would also prompt a predetermined calculation on the amount due to investors. Also keep in mind that on conversion to equity, the lower of the share price as determined by the discount or the valuation cap is used.
Pros and cons
The main advantage of a SAFE note, is its simplicity. It requires much less negotiation and provides founders with more leeway without the protective provisions. Different terms (discount and valuations caps etc.) may also be offered to different investors.
There are, however, disadvantages for both the investors and the startups. Until the next priced round of funding the investors capital does not convert to equity.
On the other hand, founders often experience a waterfall effect on conversion. This is particular prevalent when founders have not done their financial road-mapping and are then shocked when they own less of the business than they anticipated post-conversion. In order to avoid these types of scenarios, Pascal Levensohn, a venture capitalist in the USA, suggests that company counsel should prepare a pro-forma cap table before issuing any SAFE notes.
Revenue-based investment (RBI)
RBI is a type of growth capital that is exchanged for a percentage of future revenue. Think of it as a form or royalty finance.
How does it work?
It is a long-term loan (debt) that provides startups with access to funding without sacrificing any of their equity. Most importantly, it does not require equity conversion. Investors are repaid with a percentage of revenue until they have provided the investor with a fixed return on capital.
Pros and cons
Besides startups maintaining their equity (i.e., less or no dilution) and control of the company, there are other advantages. As the return on investment is based on revenue, it motivates investors to help the company succeed. It also simplifies accounting due to predicable repayments and allows for VC to be raised at a later stage.
On the other hand, startups may face a few possible disadvantages. It’s generally only applicable to later stage companies where revenue is predictable and may require personal guarantees.
In practice, the capital investment may be capped at three of four months worth of revenue and repayments to investors.
Notable mentions
Although venture capital is only considered as a funding option at a later stage, we include a brief description the newest option: flexible venture capital (VC)
Flexible VC mainly aims to bridge the gap between RBI and traditional VC. David Tenten, founder of Versatile VC, says “the flexible VC investor purchases either equity ownership, or a convertible right to equity, and a right to regular scheduled payments based on percentage of revenues.” As repayments are made, the investor’s right to equity ownership reduces. Once the agreed-upon valuation cap is reached, the investor is generally left with a fraction of the pre-revenue ownership. As to be expected, flexible VCs share some of the advantages and disadvantages of RBI.
An advanced subscription agreement (ASA) is popular in the UK and like a SAFE involves receiving cash upfront for a future issuance of equity. The equity is either issued at the next funding round or what is known as the long stop date – which ever happens first. ASAs usually involve a valuation cap and a discount, as found in a convertible note or SAFE, the difference being that investors can still benefit from UK SEIS/EIS tax reliefs when the shares are issued, provided the ASA is structured properly.
Lastly, 500 Startups in the USA has developed the Keep It Simple Security (KISS). It pairs the protective provisions found in a convertible note with the simplicity of a SAFE. There are two types of KISS agreements: Debt which includes an interest rate and maturity date, with the second being an Equity version which doesn’t include any interest rate or maturity date.
It’s important to note that no two agreements are ever the same and we are seeing hybrids, with elements pulled from other instruments, on a more regular basis.
As this somewhat technical article draws to an end, we hope you now have a much clearer understanding of equity and the difference between convertible notes, safe notes, RBIs, and flexible VCs.
