Choosing a Financing Structure

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Choosing a Financing Structure

If you have chosen to seek venture capital to fund your business, there are important choices to make regarding what type of investment structure suits your company’s needs. Venture capital investments, all of which provide capital to private companies in exchange for equity, can fall into one of three possible financing structures: priced equity (commonly referred to as “priced rounds”), convertible notes (also referred to as “convertible debt”), and convertible equity. Together, convertible debt and convertible equity are sometimes referred to as convertible instruments or convertible securities.

Until the mid-2000s, nearly every venture capital deal was done as a priced round. In 2010, Paul Graham of Y Combinator shared that every investment in the current batch of Y Combinator had been done on a convertible note.* Over the next three years, the convertible note became widely adopted beyond Y Combinator, until 2013, when Graham announced a new vehicle that would be favored, a type of convertible equity called the safe.* While the safe has overtaken the note in popularity in Silicon Valley, notes still remain popular across the rest of the United States.*

There are drawbacks and benefits to each of these financing strategies—not to mention strong opinions on all sides—and they’re not always easy to anticipate or understand. So before you make any decisions, spend some time here understanding the differences between convertible notes and convertible equity, and their terms (which may be negotiated during a financing deal). At the end, you’ll find some template documents available for both.

We’ll also break down how funder and founder interests align and compete depending on the vehicle of investment, and share advice on how to negotiate an investment structure that serves founders and investors equally. Finally, we cover some of the legal terms of financing agreements, but not all of them. For a deeper dive into the nitty gritty of legal terms, check out the section on term sheets.

Priced rounds vs. convertible instruments

In a priced round, investors purchase newly issued stock in a company at an agreed-upon price per share. A priced round is more a type of financing structure than a type of round, though it can be helpful to refer to raising a priced round as different from having raised through other types of financing structures.

A founder may say, “We raised a priced round,” meaning they sold equity in their company in exchange for investment. Alternatively, a founder may raise on a convertible instrument, of which there are two types: convertible notes and convertible equity.

Convertible instruments are used frequently in early-stage venture capital deals. While priced rounds are still the preferred mode of investment by venture capital firms, they don’t always make sense when companies are at the pre-seed or seed stages. That’s because priced rounds are most beneficial when investors and founders—buyers and sellers—can agree on the value of the company.

Definition A convertible note (or convertible debt) is a short-term loan that is designed to be repaid, plus interest if applicable, with equity in a company. A subsequent financing round or liquidity event triggers conversion, typically into preferred stock. Convertible notes may include two options for determining the number of shares for which they will be exchanged: a discount and a valuation cap, which incentivize early investors to take risks on unproven companies. If a convertible note is not repaid with equity by the time the loan is due, it must be repaid in cash like a normal loan.

Convertible notes generally specify that the subsequent financing round must raise at least a specified amount of capital for conversion to occur. Typical thresholds for a qualifying financing round are in the $1–2 million range.*

Definition Convertible equity is a financing structure that mimics convertible notes but is not technically debt and so has no interest rate or provision for repayment in cash.* Like a convertible note, convertible equity is designed to be exchanged for shares in the company at the time of a subsequent financing round or liquidity event. Convertible equity also may include a discount or valuation cap to incentivize early investors to take risks on unproven companies. The most common form of convertible equity for seed investments is Y Combinator’s safe.*

Convertible notes, originally created for use in bridge rounds, were later adapted for use in angel and seed rounds, and were popularized in the late 2000s by Paul Graham of Y Combinator. Prior to Graham’s introduction of the safe,* notes were the preferred financing structure for early stage deals. While safes are the most common structure in Silicon Valley and more mature ecosystems like New York City, convertible notes are still widely used elsewhere in the United States.

Many of the challenges for founders associated with notes have been addressed by the creation of convertible equity. There are a lot of strong opinions out there on which financing structure is best for founders, but the truth is, there are benefits and drawbacks to each option, and each option comes with its own risks.

controversy Many founders will at some point come across an advisor (another founder, a VC, et cetera) who takes the position of, “Look, your company is either going to be huge or dead. And if your company is huge you won’t care if you own 1% or 20%, so stop worrying about valuation and dilution so much. Just get the financing done and move on.” Honestly, there is a bit of truth in this, but it leaves out all the middle (and much more common) scenarios where the company sells for some amount in the low to mid-millions. There are definitely experts on both sides of this issue, and the reason this advice is dangerous is that it encourages founders to not understand their decision down to the bones.

We’ll discuss the key aspects of convertible instruments shortly, like the valuation cap and discount, which are crucial to understand if you want to avoid some serious hurt. But when deciding which financing structure is right for the round you’re raising now, there are a few points you can start with: amount, stage, certainty, flexibility, legal fees, and control.

Amount and stage

As a simple rule, most seed rounds under $1M are done on either convertible notes or convertible equity deals like safes. While it’s not entirely uncommon in Silicon Valley for rounds up to $3M or $4M to be done on convertible notes or safes, the greater a deal gets in size after $1M, the more likely it is that the deal will be done on a priced round.

Priced rounds are seen as advantageous to investors because they know exactly what the price of the equity they’re buying is at the moment of the transaction. At the earliest stages, however, many startups raising venture capital will choose to utilize a convertible instrument—like convertible debt or convertible equity—because it is nearly impossible to predict how valuable their company will be 12–24 months from the date of the transaction.

When a company is little more than two people with an idea, it’s hard to tell whether that team of two will build a company with $1M in revenue in 24 months or go bankrupt. On the other hand, when a company has been operating for a few years, is generating revenue at a steady growth rate, and investors can compare their metrics to larger companies in the same market, it’s much easier to propose a price and valuation both sides can agree to.

Certainty

Convertible instruments present uncertainties to investors that priced rounds generally do not. In a priced round, an investor knows exactly how much of a company they will own after investing. Convertible instruments defer a negotiation on price, and therefore ownership, to a subsequent round of financing past a threshold set in the term sheet. Cap and discount mechanisms in convertible instruments can be used as proxies for price in that they set a maximum price for investors at conversion. For example, if a company raises $1M on a convertible instrument with a $6M pre-money cap, the investors are not agreeing that the company is presently worth $6M, but rather saying they believe the company will be worth at least $6M by the time the company raises another round of financing.

Caps on convertible instruments can lower the risk to a palatable point for early-stage investors. We’ll explain this in detail later, but the way this works is, if—using the same example—the company raises its next round of $4M on $12M pre-money, the early stage investors will pay much less per share for their stock than the new investors, because of the cap. Founders should be cautious, however, as an investor can end up getting an absurdly good deal—and founders’ ownership will get heavily diluted—if they invest on a low cap and the company ends up raising the next round on a valuation significantly higher than the cap.

Flexibility

Because of the uncertainty around how much a business is worth and how much a risk an investment is, early-stage companies struggle to find a lead investor to set a price in a priced round. The major benefits of both convertible debt and convertible equity is that these approaches allow you to raise smaller amounts of money from more investors, you don’t need someone to act as lead investor, and you can adjust your terms as the fundraising process evolves.

important One of the attractive elements of convertible instruments is how they recognize the highly dynamic nature of value creation in an early-stage company. In a priced round, founders must know how much money they need to raise, and sell equity in exchange for that money at a fixed price they deem favorable. Convertible instruments allow for a more dynamic style of fundraising, which Paul Graham coined as “high resolution fundraising.”

With this method, a company can raise a smaller amount of capital at one price when the company is small, and more capital at a higher price as the company garners more investor attention. This is possible with the low cost, and speed, associated with convertible notes.

When a company is just getting started, they may not be able to predict how much money they’ll need to operate and reach milestones for 24 months. Additionally, the value of an early-stage company can drastically change month-to-month. For example, one month a company may just be two founders, and six months later they may have four employees, ten customers, and $100K in revenue. When they’re two people, they can raise a little bit of capital at one price, and more at a higher price when they’re six.

Raising money is expensive. Priced rounds require complicated paperwork to align founder and investor expectations, particularly around who gets paid how in the event of an exit, and to make the terms of the investment legally enforceable. Often, the legal paperwork supporting a priced round can range from $50K–$100K, and in rare cases even more.

When the total round size is below $1M—or even slightly above it—it seems silly (and possibly insane) to spend 5–10% of the overall investment on the legal fees a priced round requires. Because of the flexibility allowed with convertible instruments, it’s easier to execute the necessary legal documents with investors, so you won’t spend as much on legal work as is required when you raise a priced round.

One of the main draws of convertible instruments is that they involve less paperwork and lower legal fees than equity financing. A Series A can cost $50K or much more in legal fees. With convertible notes, you can spend as little as a few thousand dollars to secure a loan that later converts into equity.*

caution But, as with everything else in the convertible universe, there is a catch. In some cases, investors will require you to cover their legal expenses as well, just as they can do with a priced round. Moreover, convertible instruments that convert to preferred stock entail more complicated paperwork than notes that don’t, and more complicated paperwork means more money paid to lawyers.*

Many investors and founders raising money through convertible instruments use templates often referred to as “standard docs.” Standardized template documents, like the open source Series Seed documents, make it possible to raise a seed round for $1,500–$2K in legal fees, because they cut down on the time needed to negotiate a large set of terms.*

caution But just because someone tells you the paperwork is on “standard docs” doesn’t mean the terms in that template will all be in your favor. Be sure to pay attention and have a lawyer involved in the negotiation so you don’t agree to something against your interest.

No matter what financing structure you raise with, legal fees are negotiated as part of the term sheet.

Control

Priced rounds (equity financings) are not debt like convertible notes are. While founders may give up some control of their company via protective provisions and board seats in an equity financing, investors will not have the right to force a company into bankruptcy by choosing to collect on the debt.

danger Convertible notes are often heralded by investors and founders alike as one of the cheapest, fastest ways for a young company to raise money. Unfortunately, very few founders understand how much control debt of any kind gives the lender. Let’s be clear: there is nothing more powerful than being the holder of a company’s debt when that debt has matured and is due.

This means that if a company does not have the money to repay the holder of a convertible note—which is debt!—when it has matured, the investor can force the company into bankruptcy.

How could this work in practice? Imagine this scenario: A company raised $500K on a convertible note with a one-year maturity date. A year later, that company is almost out of money and goes to the investor who invested the $500K on a convertible note and asks for $500K more. The investor turns around and tells the company they’ll either invest $500K for 50% of the company in a priced round or call in the debt, which would force the company to choose between a very bad deal and death. Even crazier is that a company may have raised $1M on convertible notes, and a single $25K note holder can extort the company like this for more equity after the loan’s maturity date—even if the other holders of $975K act in the company’s interest.

important Companies can avoid this issue by inserting a term that requires the convertible debt to convert into common stock at the end of the maturity period. This will work in the company’s favor, as investors will want the stock to convert to preferred stock and will then have an incentive to extend the maturity date until the company raises another round that converts the investors stock to preferred.

Elements of convertible instruments

The elements of convertible debt and convertible equity that we list here, including amount and interest, most favored nation clause, the valuation cap, and discount, are all terms that will come up in your term sheet if your company uses one of these financing structures. As with any financing structure, you will also negotiate legal fees as part of the term sheet.

Interest

If you choose to make a deal on a convertible note, you’ll be negotiating an interest percentage on the loan, which will accrue between the time the loan is issued by the investor and the time it converts.

Definition Interest is a type of fee that a borrower must pay their lender on top of repaying the loan itself, and it is calculated on a regular basis as a percentage of a loan. Interest motivates lenders to lend their money rather than use it in some other way and protects them from the risk that their loan may not be paid back under the agreed terms. Interest is often casually referred to as the “cost of borrowing money,”* although technically the cost of borrowing also includes any applicable fees.*

Interest rates for loans of convertible debt are usually between 4% and 8%, though FundersClub reports rates can go as low as 2%.*

Most favored nation

Definition A most favored nation (MFN) clause in a convertible note or convertible equity allows the investor to exchange the terms of their convertible instrument for better terms offered in a subsequent convertible instrument. The MFN clause also requires the company to share information about subsequent convertible instruments with the investor so that the investor can compare the terms. Typically, MFN clauses last until the convertible instrument has converted into stock or otherwise been repaid.* An MFN clause is included in 500 Startups’ KISS, both the debt version and the equity version, and in one of the four safe versions.

Currently only about 10% of pre-seed convertible instruments include an MFN clause.* Because of the additional coordination that keeping the investor informed requires and the potential for giving away value down the road, agreeing to an MFN clause in a convertible instrument definitely involves trade-offs and should be done thoughtfully.

Valuation cap

If you use a convertible instrument for your first round of financing, you will have to agree with the investor on whether to include a valuation cap and, if you are including one, what it should be. This is where things get tough.

Definition A valuation cap (or cap) is an optional element of convertible instruments that offers a price per share at conversion that is pegged to a mutually agreed upon valuation of the company. If the company’s valuation in the next priced round exceeds the valuation cap, then the price per share for the convertible instrument investors is the valuation cap divided by the fully diluted number of outstanding shares. If the valuation in the priced round is lower than the valuation cap, the convertible instrument investors pay the same price per share as the new investors. An uncapped note is a convertible note that does not have a valuation cap.

danger Be careful when setting valuation caps. First, the greater the distance between the valuation cap and a higher valuation in the next priced round, the greater the difference in prices per share for the two groups of investors. This means you may wind up giving away part of the company at a cut-rate price and dilute your ownership. However, valuation caps can pose risks for convertible instrument investors as well: The valuation cap may unintentionally limit the company’s valuation going forward by anchoring priced round investors’ expectations.* In “Just Say No to Capped Convertible Notes,” author and investor David Hornik of August Capital argues that capped notes are the investment equivalent of a coin flip in which the investor and entrepreneur have equal chances of getting a raw deal. The article is a warning to all entrepreneurs to pause and consider the disadvantages of capped convertible notes.

important When negotiating a term sheet for a convertible that does include a cap, don’t forget to discuss whether the cap is pegged to a pre-money or post-money valuation. If you are planning for a pre-money conversion, but the investor is thinking in terms of post-money, you could end up with unexpected results. As Brad Feld has noted, most convertible notes are ambiguous in this respect, which can cause significant confusion. Instruments may be left ambiguous to create space for negotiation down the road, but this should only be done carefully and intentionally, not because you forgot to specify how conversion would work.

To see how valuation caps work, consider this scenario from the perspective of the company’s first priced round (Series A):

  • Convertible instrument investment: $600K
  • Valuation cap: $1M pegged to pre-money valuation
  • No discount option.
  • Series A valuation: $2M pre-money, $3.6M post-money
  • Series A price per share: $5
  • For the purposes of this example, assume there is no option pool allocated and no interest on the convertible instrument.

Since the company’s Series A valuation is higher than the valuation cap, the cap comes into play. This round values the company at $2M pre-money with a price per share of $5, so there are 400K shares ($2M valuation / $5 price per share = 400K shares).* Because the valuation cap applies, divide the valuation cap by the number of outstanding shares before the Series A investment to determine the conterible instrument investor’s price per share (cap / shares = adjusted price per share). In this case, that will be $2.50 ($1M cap / 400K shares = $2.50 price per share). Compare this to the Series A investor’s $5 price per share.

The valuation cap also helps the convertible instrument investor claim a larger ownership percentage than the Series A investor for less money. Dividing the Series A investor’s $1M by a $5 share price, they receive 200K shares ($1M investment / $5 price per share = 200K shares). Dividing the convertible instrument investor’s $600K by the lower valuation cap price of $2.50 per share, they receive 240K shares ($600K investment / $2.50 price per share = 240K shares). Thus, out of a new total of 840K shares, the Series A investor gains a 23.8% ownership interest (200K shares / 840 shares = 23.8%), and the convertible instrument investor gains a 28.6% interest (240K shares / 840K shares = 28.6%). Moreover, the founder has been diluted to only 47.6% ownership (400K shares / 840K shares = 47.6%).

In cap table format:

Number of Shares% Ownership
Founders400K47.6%
Series A Investors200K23.8%
Convertible Instrument Investors at Series A240K28.6%
840K100%

You can get a sense of the valuation cap’s effect even if you don’t know the price per share or number of shares in the Series A round. Divide the Series A valuation by the cap amount and you’ll get the value multiple at which the instrument converts with the cap ($2M Series A valuation / $1M cap = 2). Multiply this by the convertible instrument investment and you’ll find the amount a Series A investor would have to pay to get the same number of shares that the convertible instrument investor has paid $600K for ($600K * 2 = $1.2M), even if you don’t know exactly how many shares that is. Conceptually that's unsurprising because the Series A valuation is double the valuation cap at which the convertible instrument converts.

If the valuation cap and the Series A valuation were equal, or if the Series A valuation were lower than the valuation cap, then the convertible instrument investor and a Series A investor would pay the same price per share. But, even without the cap, the convertible instrument investor still benefits by receiving a larger ownership interest than they might otherwise have obtained. Founders and investors sometimes estimate the ownership interest expected from convertible instruments by dividing the investment amount by the valuation cap ($600K investment / $1M valuation cap = 60%). As we’ve already seen, convertible instrument investors don’t always get this much ownership (28.6% in the example above). But suppose the cap is $5M with all other terms held constant. The convertible instrument investor might expect 12% ($600K investment / $5M valuation cap = 12%), but they would get more. The founder and Series A investor would have the same number of shares, while the convertible instrument investor would have 120K shares ($600K investment / $5 price per share = 120K shares). Thus, the convertible instrument investor’s ownership interest would be 16.7%, rather than the 12% (120K / (400K + 200K + 120K) = 120K / 720K = 16.7%).

In addition to considering how much of the company you are willing to sell (and how much ownership you want to maintain), you also have to consider the market when setting a valuation cap. For a relatively unknown first-time founder raising their first round, you’re likely not going to be setting the cap for over $3M. If you’re relatively well-known, you could get a $5M–$8M cap. If you’re really well-known and investors have a lot of confidence in you based on past performances in other companies, you might be raising a priced round or uncapped note out of the gate.

Keep in mind that the valuation cap is not necessarily an expression of the valuation that the company has now or will have in the next round. Instead, it’s primarily a mechanism for offering an investor a premium on their investment, which gives them a reason to hand over their money. A lower cap can mean the difference between $100K at $0.05 per share and $100K at $0.10 per share for an investor. This is especially attractive for early-stage investors considering putting money into a relatively unproven company where the risks are greater.

In our section on price, dilution, and valuation, we showed that price per share, dilution, and valuations are really three different ways to view the same thing—the value of ownership in the company. To do so, we walked through a detailed scenario of what it means when people say things like, “A company raised $1M on a $6M post-money valuation.” Capped convertible instruments start to complicate this picture because a cap may lead to different prices per share for the convertible instrument investors and the priced round investors.

confusion Valuation caps are confusing. If you’re still not sure how they work, these three scenarios may help you understand the purpose and possible consequences of the cap:

  • Cap greater than subsequent valuation: While this is rare, it does happen. Consider a company that raised $1M with a $5M cap on a convertible note but is now raising $1M in equity financing on a $4M post-money valuation.

    • This scenario isn’t ideal from a progress standpoint, but it only hurts founders by setting a low price, which means selling more equity for less money.
  • Cap less than subsequent valuation: Consider a company that raised $1M with a $5M post-money cap on a convertible note, but is now raising $3M in equity financing on a $10M post-money valuation.

    • This scenario works in favor of the investor holding the convertible note. The new investors will now be paying a higher price, but the convertible-note investors’ price per share will be calculated as if the company’s post-money valuation were $5M, not $10M.
  • Cap equal to subsequent valuation: If the cap is equal to the next round’s valuation, then the note converts into equity at exactly the price everyone expected. The investor doesn’t lose or gain money on the loan, with the exception of interest. The longer the time between the issuance of the note and the occurrence of the equity round, the more interest has accrued, and the greater the dollar amount of the loan upon conversion to equity.

To complicate matters even further, valuation caps aren’t the only option for adjusting a convertible instrument investor’s price per share in the next priced round. Convertible instruments can also include a discount, and they often employ both price adjustment mechanisms together.

Discount

Definition A discount is an optional element of convertible instruments that offers a percentage-based reduction in price per share when the instrument converts into equity in a subsequent priced round. Like a valuation cap, a discount rewards investors for taking an early risk on a company, allowing them to convert to equity at a lower price than the priced round investors pay per share. In early-stage financing, convertible notes and convertible equities often specify both a valuation cap and a discount—when the priced round occurs, the investor chooses either the cap or the discount, depending on which is more favorable.

Typical discounts for early-stage convertibles are in the range of 5–30%, which translates to paying 70–95% of the share price paid by the equity investors. A 20% flat discount appears to be industry standard (as of 2019), which applies regardless of when the note converts.* According to David Lishego, Senior Associate at Innovation Works, “some deals specify a stepped discount that increases the longer the note is outstanding, for example, 20% if the note converts within 12 months of issuance and 30% if the note converts beyond 12 months of issuance.”*

For a simplified discount example, consider a variation on the example discussed in Valuation but assume the convertible instrument is uncapped and includes a 20% discount instead:

  • Convertible instrument investment: $600K
  • Discount: 20%
  • No valuation cap.
  • Series A valuation: $2M pre-money, $3.6M post-money
  • Series A price per share: $5
  • For the purposes of this example, assume there is no option pool allocated and no interest on the convertible instrument.

Unless the instrument includes special conditions, the discount will apply no matter the Series A valuation amount or price per share. The convertible instrument included a 20% discount, which means the discounted price per share will be $4 while the Series A price per share is $5 ($5 price per share (1 - 0.2 discount) = $5 0.8 = $4 discounted price per share). Dividing the original investment by the discounted price per share shows that the convertible instrument investor will get 150K shares for their $600K investment ($600K investment / $4 discounted price per share = 150K shares). Compare this to the $750K that a Series A investor would have to pay to purchase 150K shares (150K shares * $5 price per share = $750K).

You can also get a sense of the discount’s effect even if you don’t know the Series A price per share. Simply divide 1 by 1 minus the discount and you’ll get the value multiple at which the instrument converts with the discount (1 / (1 - 0.2 discount) = 1 / 0.8 = 1.25 multiple). Multiply this by the convertible instrument investment and you’ll get the amount the Series A investor would have to pay to get the same number of shares that the convertible instrument investor will get from the discount ($600K investment * 1.25 = $750K).

Unfortunately, it’s not usually that simple. As we’ve mentioned, most early-stage convertible instrument financings have both a valuation cap and a discount,* so you should be familiar with the dynamics that creates.

Choosing between a valuation cap and a discount

In a subsequent priced round, the investor will choose between whichever is more financially desirable, the cap or the discount. Startup and VC lawyer Chris Harvey provides an example (originally published on Quora* and adapted for this Guide) of how this works:

Here’s the equation you can use to figure out whether the valuation cap (based on a pre-money valuation) or the discount will apply:

$X = valuation cap / discount rate

If the pre-money valuation is greater than $X, you will apply the valuation cap. If the pre-money valuation is less than $X, you will apply the discount.

Discount rate = 100% − discount

For a 20% discount, the discount rate is 80%, not 20% (100% − 20% = 80%). In the case of a 30% discount, the discount rate would be 70%.

For notes that include both a discount and a cap, the notes will typically specify that the conversion price will be the lower of:

  1. the price per share by applying the discount to the next qualified financing preferred stock price (e.g., $1.00 per share of Series A preferred), or
  2. the price per share found by dividing the valuation cap by the company’s pre-money valuation.

This means that the investor receives the better of the two possibilities—lower conversion price per share means that the note converts into more shares in the Series A.

Let’s walk through a couple of scenarios, assuming the following:

  1. Convertible note principal amount = $100K

  2. Series A investment = $1M

Scenario 1: $4M valuation cap, 25% discount, $7M pre-money valuation

If the discount is 25%, the cap is $4M, and the pre-money valuation is $7M, we don’t need to know what the exact conversion price will be to know that the valuation cap will apply. How do we know that?

$X = $4M / 75%

$X = $5.33M

To show you how those numbers work, let’s assume the price per share of the Series A investors is $1.00 per share. What kind of a discount would apply to the safe holders with the numbers above?

Applying the discount, the conversion price is $0.75; but if we divide $4M (the cap) by $7M (the pre-money valuation), we get $0.57 per share. Because that number is lower than the conversion price of $0.75, the valuation cap applies, not the discount.

Scenario 2: $4M valuation cap, 25% discount, $5M pre-money valuation

But what happens if the pre-money valuation is $5M—should the valuation cap or discount apply?

Applying the discount, the conversion price is $0.75; but if we divide $4M (the cap) by $5M (the new pre-money valuation), we get $0.80 per share, a higher number than the $0.75 conversion price. Now the discount applies, not the valuation cap, because the discount gives investors a lower per-share price.

confusion This is counter-intuitive because the pre-money valuation exceeds the cap by $1M. But unless the pre-money valuation is greater than $5.33M, the cap would not be triggered ($4M divided by 75% equals $5.33M).

Downstream consequences: exits

danger Many founders, at the time of a liquidity event, are shocked to learn that they can sell their company for millions of dollars without a penny making it into their personal bank account.

To fully understand the implications of your early-stage financing choices on valuation and dilution, it helps to play this all the way through to a liquidity event. To do so, you need to understand a few more key concepts: preference, conversion of preferred stock to common stock, and participation. We’ll lay out the most common scenario here (1X non-participating preference), and you can get the rest of the gory details in the section on term sheets.

Preference

Definition A liquidation preference (or preference) is a contractual clause that sets the order and, in some cases, the amount of payout for a company’s creditors and holders of preferred stock in case of a liquidity event. Preferred stock usually has a liquidation preference and, when this is the case, holders of preferred stock get their investment back before holders of common stock are paid.

Preference means that preferred shareholders get paid before anyone else. You’ll often see preference expressed as “a 1X liquidation preference,” where the 1X refers to the multiple—that is, a return of the original investment amount. A 1X multiple is the most common. 2X (or even higher) multiples were common during the crash of the 1990s dot-com era. Today, only 19% of deals have a 2X or greater liquidation preference.** (For biotechnology and life sciences companies, the multiple can be 2–3X, likely due to the much larger amounts of up-front capital required to start these kinds of companies.)

The important thing to understand about preference is that, in the case of a liquidity event where the investment return via preference is less favorable than what common stockholders would receive (which would be the case in a big exit like an IPO), preferred shareholders would choose to convert their preferred shares to common.

Definition Liquidation preference overhang (or liquidation overhang) is an outcome of exchanging a convertible note or convertible equity for preferred stock in which the resulting liquidation preference is greater than the original investment. Liquidation overhang can occur where the original investment included either a conversion discount or a valuation cap, allowing the investor to acquire preferred stock at a reduced price per share.

For example, if an investor invested $1M on a safe with a 20% discount and they convert to full-value preferred stock, they’ll get shares with a liquidation preference of $1.25M. The discount and cap, on convertible debt and equity, were created to give early investors more ownership because they were taking a risk on an untested company. The liquidation overhang, however, gives the investor even more.

dangerSignificant liquidation overhang can have drastic consequences: Holders of common stock will receive no payout in a liquidation or liquidity event if the company’s value at that time is less than or equal to the amount of the aggregate liquidation preference, holders of preferred stock exercise their liquidation preference, and there is no particular protection for common stock. Even very large exits can produce no payout to the common stock if, as a result of a history of large financings with substantial liquidation preferences, there is a liquidation overhang.

There are two ways to give early investors more shares—in accordance with the risk they took—without the liquidation preference overhang.

  1. Create the discount via common stock: Investors get preferred stock up to the aggregate amount of their liquidation preference and then all their discount shares are issued via common stock. This is ideal for founders. Less experienced investors may bristle at using common stock to create the discount because they can’t mark the full value of their position in your company as high when reporting to their LPs, as common stock is valued separately (via 409A) from the preferred price. Experienced firms should be comfortable with this, because they know this will not be material to the long-term performance of the investment. If an investor does challenge you on creating the discount via common stock, this is a red flag that the investor may not have your best interests in mind.

  2. Offer an additional class of stock with a lower per-share liquidation preference so that the investor’s aggregate liquidation preference stays the same, but they still get additional shares.

Definition Shadow preferred stock is a separate series of preferred stock that is designed for use with convertible instruments and calculates per share liquidation preference, conversion price, and dividend rate based on the original investment amount in the relevant convertible instrument. Except for these distinctive features, shadow preferred stock has the same rights, privileges, preferences, and obligations as the series of preferred stock issued to new investors. Shadow preferred stock is designed to solve the problem of liquidation overhang associated with convertible instruments. Investors whose convertible instruments are exchanged for shadow preferred stock still get the benefit of purchasing shares at a discounted price, but their liquidation preference cannot exceed their original investment.

controversy Shadow preferred stock is controversial because, while it converts to the same class of preferred stock, it is a separate series of preferred stock, which grants its holders rights to block certain actions under Delaware constitutional law (remember, most startups are Delaware C corporations).

dangerSome lawyers have raised concerns that shadow preferred stock can complicate future deals such as merger and acquisition offers, in the case that holders of shadow preferred stock feel that their ownership position is being adversely affected.

By way of illustration, let’s assume the following: 1. 1M shares of common stock outstanding on a fully-diluted basis. 2. $100K convertible instrument outstanding with a $10M valuation cap. 3. The $10M valuation cap means the convertible instrument converts at $10.00 ($10M/1M shares). 4. $20M pre-money Series Seed round valuation, resulting in a per share price for new cash investors of $20.00 ($20M/1M shares). 5. The Series Seed preferred stock has a 1X participating liquidation preference (each share of Series Seed preferred stock will have a liquidation preference of $20.00). 6. The $100K in convertible instruments will convert into 10K shares ($100K/$10.00 per share).

If the convertible instruments convert into 10K shares of the same Series Seed preferred stock as the new money Series Seed investors, then the convertible instrument holders would have a total liquidation preference of $200K (10K shares multiplied by $20.00 per share). So an original $100K investment would result in a $200K liquidation preference, which is equal to a 2X liquidation preference rather than the 1X liquidation preference the new cash investors will receive. If the convertible instruments instead convert into 10K shares of a shadow series (like Series seed-1 preferred stock) with a per share liquidation preference of $10.00, then the original $100K investment results in a $100K liquidation preference, which is equal to the 1X liquidation preference the new cash investors will receive.

Conversion to common stock

Definition Conversion rights are a feature of preferred stock that governs how and when it is exchanged for common stock. Optional conversion, which is the most frequently seen form of conversion right in venture capital term sheets,* allows investors to choose when and whether to exchange their preferred stock for common stock. In a liquidity event, preferred stockholders with optional conversion rights will typically exercise them if the proceeds from converting to common stock are greater than the value of their preferred stock’s liquidation preference, any accrued dividends, and participation rights. By contrast, an automatic conversion (or mandatory conversion) provision specifies conditions under which preferred stock must be exchanged for common stock. Typical conditions are: when a majority of preferred stockholders consent, or in the event of an IPO that meets specified criteria for overall company valuation and price per share.*

Participation

Definition In a liquidity event, participation rights (or participation) govern how proceeds are distributed to preferred shareholders*—that is, how they participate in the distribution. An investor with full participation rights (or participating preferred) is paid according to the liquidation preference agreement, plus a pro rata portion of what remains as if it converted to common stock—in effect, being paid twice. An investor with capped participation rights is also paid according to the liquidation preference and a portion of what remains, but their payout cannot exceed a predetermined figure, generally calculated as a multiple of their initial investment.

Participation is complicated because it is not exactly what it sounds like. All preferred stock “participates” in the upside of a liquidity event because preferred is always optionally convertible into common stock by the investor. In particular, capped participating shareholders might choose to convert to common shares if that is a more favorable outcome for them. Participation, in the legal sense you encounter it here, means that the investor gets their preference in addition to participating in additional returns alongside common stockholders (either in full, or up to some capped amount).

But the vast majority of the time, you’ll encounter non-participating 1X preferred, which gives investors two options in a liquidation event. First, the investor can opt to exercise just their liquidation preference. Second, the investor can opt to convert their preferred shares into common and participate pro rata in the liquidation proceeds as a common stockholder would.

In the event of a tremendous exit, all of the preferred stockholders would agree to forego their liquidation preference and be treated as common stockholders in order to take more of the exit. This can have a significant impact on dilution for a founder.

Consider this example from Capshare:*

Imagine shareholder A has 100 shares of preferred stock worth 10% of the company and a 1X liquidation preference. For the sake of easy math, let’s say the shares are worth $1 a piece. During liquidity, the shareholder would reach 100 dollars and stop participating. They got 1X their shares, but they didn’t receive 10% of the company. Now, let’s say that shareholder A had negotiated a 1X liquidation preference and 2X conversion rate to common stock. Instead of walking away with $100, the shareholder would convert to common stock, and double his/her shares to 200 and thus 18.18% of the company.

TL;DR: This stuff is crazy complicated. A few folks have created some templates to help you with this—the most common one (at least in Silicon Valley), is the safe, which we discuss in detail next.

Template documents for convertibles

controversy Various sets of templates for early-stage financing documents are available online. Templates save you time so you can close the round fast, but—despite popular belief to the contrary—even template documents may contain unfavorable terms. You will inevitably hear the phrase “standard documents” or “standard docs.” This is a reference to template documents, but it’s misleading. There is no such thing as a “standard set of documents.” Every law firm has their own set and everything is redlined in a negotiation. In any case, be sure to understand the terms you agree to, and consult a lawyer before you sign anything.

You can execute a convertible instrument agreement by working with a lawyer and drafting your own documents. Alternatively, you can use standardized convertible instrument paperwork from accelerators and other startup programs and institutions.

controversy These tools try to simplify the convertible instrument process, and are known for controversial approaches to eliminating downsides for investors.

Here are three well-known sets of these standardized agreements. The law firm Rubicon provides a thorough side-by-side comparison of safe and KISS.

Y Combinator’s Safe

Definition A safe (Simple Agreement for Future Equity, or SAFE)* is a type of convertible equity that was designed by the accelerator Y Combinator. Y Combinator offers four versions, which differ on valuation cap, discount, and inclusion of a most favored nation clause, plus an optional pro rata side letter. All versions except the one that includes an MFN clause convert into shadow preferred stock. In the MFN version, the safe converts into standard preferred stock. Y Combinator partner Carolynn Levy created the safe as an alternative to convertible debt in 2013.*

caution While using a safe will reduce the legal fee of your deal, founders should make sure to familiarize themselves with the risks of shadow preferred stock.

important In September of 2018, Y Combinator announced two changes to the safe documents. First, safes now calculate ownership using post-money valuations instead of pre-money. Second, granting pro rata rights to safe holders is now optional. There are positives for founders here, particularly in that tracking dilution is easier with the post-money safe. But these moves are in part a response to criticism that the safe wasn’t friendly to investors, so founders should beware. Founders can still use the pre-money safe, but either way, it is important to understand the differences, especially if you’re in California, where the safe is popular. If you are considering using the safe, we highly suggest reading through the Extra Crunch comparison of the pre-money and post-money versions; which one is best for you will depend on the stage of your startup and your expectations for your next fundraising round.

controversy Also at Extra Crunch, startup attorney José Ancer shares an important perspective on the safe vs. convertible equity debate, in light of recent changes to the safe: “My first piece of advice is that a convertible note with a long maturity (three years) and low interest rate (like 2 percent or 3 percent) will give them functionally the same thing—while minimizing friction with more traditional investors.” For all the details backing up Ancer’s opinion, read on. For the changes to the safe from a pro-safe perspective, Ramy Adeeb breaks it down.

Y Combinator offers various versions of safes (like “valuation cap, no discount” and “valuation cap and discount,” as well as a pro rata side letter) free to download.

500 Startups’ KISS

Definition KISS, which stands for “keep it simple security,” is a set of free convertible instrument templates provided by the accelerator 500 Startups. The set includes a convertible debt template, a convertible equity template, and a summary of the key terms in each. The debt version has both valuation cap and discount options for conversion, accrues interest, and can be repaid in cash before conversion is triggered. The equity version has a cap and a discount, no interest, and no option for cash repayment. Both versions include 1x participation rights for major investors, which 500 Startups defines as those investing more than $50K,* and a most favored nation clause.

TheFunded.com’s templates

TheFunded.com, an online community for founders and CEOs, and accelerator Founder Institute created a set of standardized documents for convertible equity with the help of law firm Wilson Sonsini. These templates allow parties to tweak terms like cap and discount to suit their needs and desires.

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