What You’ll Read

• Common security types that entrepreneurs use to raise capital
• Key negotiation points for entrepreneurs and investors
• When founders should use each type of security

Key Takeaways

• When entrepreneurs raise capital from investors, they will typically issue one of three types of securities: convertibles, equity, or debt.
• Entrepreneurs and investors will spend most of their time negotiating the economics and control terms of a fundraising round.
• Side letters are used to grant certain investors privileges that are not offered to other investors as part of the fundraising round.
• Convertible securities are most often used for early-stage fundraising rounds, while equity and debt securities are often used in growth and late-stage fundraising rounds.

The fundraising journey is full of key considerations that are often misunderstood by both first-time and experienced entrepreneurs.

As you raise capital from investors, you’re typically negotiating with professional deal makers—investors who have had hundreds or thousands of repetitions.

In this article, we’ll explain what you need to know during your fundraising journey so you can enter into your investor conversations with confidence.

Common security types that entrepreneurs use to raise capital

When you decide to raise capital from investors, one of the first questions you must answer is, “What exactly will investors be buying?”

There are several types of securities that entrepreneurs can use to raise capital. These securities generally fall into three categories:

Convertibles

Just like the name suggests, convertible securities are financial instruments that can be converted into equity at a future date.

This type of security is favorable to entrepreneurs at the earliest stages of company formation because of the ease and relative cost-savings for issuing convertible securities. Convertible securities also allow entrepreneurs to delay the valuation component of raising capital, particularly when a company is too young for the market to appropriately value.

Importantly, you should be careful to not raise too much capital using convertible securities early on as this can cause steep dilution in the future. As you raise capital using convertible securities, it’s important to maintain a clean cap table with future conversion scenarios to understand what your dilution could look like at the next qualified financing when the securities convert into equity.

There are two main types of convertible securities: convertible notes and SAFEs.

Convertible Note

A convertible note is a convertible debt security—a financial instrument that is issued as debt with a maturity date and interest rate—but converts into equity upon the next qualified equity financing.

Convertible notes are typically issued with a valuation cap—the maximum valuation that an investor’s note will convert into equity at—and a discount rate—a discount to the price per share at the next qualified financing.

These two mechanisms benefit early note investors to accept the additional risk of investing at an earlier stage in a company.

Simple Agreement for Future Equity (SAFE)

SAFEs, like convertible notes, are convertible securities that convert to equity at the company’s next qualified financing round. These too are commonly issued with a valuation cap and a discount rate.

However, SAFEs are not considered debt securities; therefore, SAFEs are typically not issued with a maturity date or interest rate. These securities do not ever have to be paid back to investors if there is no future qualified financing event.

SAFEs can be issued as a pre-money valuation or a post-money valuation, each one determining the conversion math upon the next qualified financing.

SAFEs have become the most common security type for early-stage companies and are friendly to both investors and entrepreneurs.

Equity

When entrepreneurs raise capital by issuing equity to investors, investors receive shares in a company at an agreed-upon price. This is the most common way to raise capital in growth-stage and late-stage companies.

Entrepreneurs issue two types of equity securities: preferred equity—or preferred stock—and common equity—or common stock.

Preferred Equity

Preferred equity is typically given to investors in a company. This type of stock is considered to be less risky than common stock because it has seniority over common stock in the event of a company’s liquidation. Preferred stock is entitled to dividends before common stock receives any income.

Preferred equity can also come with many additional benefits that make it a better deal for investors as we will discuss below.

Common Equity

Common equity is usually held by company founders and is also granted to executives and employees. Common shareholders receive fewer benefits than preferred shareholders, including being paid after preferred shareholders in the event of a liquidation event.

Debt

Entrepreneurs in the private markets raise debt capital for a variety of reasons, from inventory financing to working capital lines of credit.

However, venture-backed entrepreneurs typically use debt capital sparingly and strategically.

The most common form of debt financing for venture-backed startups is called “venture debt.”

Venture Debt

Venture debt is a type of loan that is granted by lenders specifically for high-growth venture-backed companies.

While multiple rounds of venture capital financing can dilute the equity ownership of entrepreneurs and investors, venture debt serves as a non-dilutive alternative for entrepreneurs to access capital without selling more shares of their company.

Importantly, venture debt is typically only granted to companies that have raised venture capital financing, can clearly define their performance objectives over the next several months, and is usually capped at an amount benchmarked to a percentage of their last equity financing round.

Choosing how to raise capital is an important decision. Whether an entrepreneur raises capital using convertibles, equity, or debt, it’s important to consider the key differences like the cost of capital, your company’s ability to service debt payments, and the dilution you’ll undertake by raising equity capital.

Key negotiation points for entrepreneurs and investors

Brad Feld, author of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, famously said, “As you'll learn, there really are only two key things that matter in the actual term sheet negotiation—economics and control.”

While there may be several topics of negotiation, entrepreneurs and investors will spend most of their time negotiating the economics and control details of a fundraising round.

Economics

Economic rights included in a term sheet will detail investor ownership, as well as who gets paid first, and who can participate in future fundraising rounds. Common economic provisions include:

• Valuation: The price that investors are willing to pay for part of your company. A pre-money valuation is required to be set for priced equity rounds, as well as a valuation cap in convertible securities. The valuation that a company sets for their priced equity round translates into a price per share which determines how many shares each investor owns for their investment.

• Conversion rights: The qualifying terms and price in which preferred stock can be converted into common stock. Conversion rights include both “optional” conversion rights, and “mandatory” conversion rights, also known as automatic conversion.

• Option Pool: Equity compensation is common for employees so that they have a stake in the upside of the company. A term sheet will typically detail the total size of the employee option pool and change in size upon a new qualified financing round. Investors prefer that the employee option pool shares be included in the company’s pre-money valuation to reduce excess future dilution.

• Vesting: The length of time and structure of how entrepreneurs “earn” their equity. A common vesting structure is monthly vesting over the course of four years with the first twelve months granted at the entrepreneur's one-year anniversary, called a “one-year cliff.” Vesting provisions are meant to create long-term alignment between the entrepreneur and investors, as well as protect the company against an entrepreneur’s early departure.

• Pay-to-play: A provision that requires investors to participate in future fundraising rounds in order to maintain their ownership percentage or certain rights. Not only are pay-to-play provisions meant to benefit participating investors, but these provisions can also punish non-participating investors, for example, by converting their preferred shares to common shares. These provisions are more commonly enforced in down markets when entrepreneurs struggle to raise capital.

• Anti-dilution: Protects investors from significant value destruction as a result of a down round. Anti-dilution provisions are either one of three: full ratchet, broad-based, or narrow-based weighted average—all of which determine an updated conversion ratio for preferred shareholders to maintain their ownership when converted to common shares.

• Pre-emptive rights: Also referred to as “Right of First Refusal” (ROFR) provides current shareholders the first right to purchase their proportional amount of shares from any shareholder that wishes to sell. This must be offered to all existing shareholders before the selling shareholder may offer their shares to the public.

Control

• Board of Directors: This clause addresses how many members will constitute the Board, how the Board will be chosen, and who is entitled to vote for Directors.

• Protective provisions: Requires a certain threshold of approval from shareholders on certain company decisions. This may give investors the ability to veto certain decisions that are contrary to their interests. Protective provisions protect the interests of minority shareholders.

• Drag along rights: An agreement that allows the majority voting shareholders to compel minority shareholders to participate in the sale of a company on the same terms. Drag-along rights typically benefit preferred and majority shareholders over common and minority shareholders. This provision typically leads to an easier exit process by allowing majority shareholders to force a sale through irrespective of minority shareholders objecting to a sale.

• Voting rights: Provisions that outline how corporate matters are to be decided and which corporate matters must be voted on by which shareholders. Voting rights may differ based on each share class and whether matters are for director-only voting, or include other shareholders.

Side letters

Side letters are used to grant certain investors privileges that are not offered to other investors as part of the fundraising round.

This can be the result of negotiations that an entrepreneur has with an individual firm but doesn’t want to offer to all investors.

Common side letter agreements can be written for more favorable liquidity terms, board representation, and pro-rata rights.

Entrepreneurs should issue side letters with caution. It’s possible other investors in the round will request those same privileges. In some cases, side letters can set a precedent of what other investors will request as well.  

When founders should use each type of security

Deciding on the type of security to issue is a key component of your fundraising strategy.

Convertible securities are favored for their simplicity and cost-effectiveness to issue, as well as the ability to delay setting a valuation for the company. For these reasons, convertible securities are often used by early-stage founders in their pre-seed or seed round, or during a bridge round—a quick infusion of cash between priced equity rounds in order to extend a company’s financial runway.

Equity securities are commonly used in growth and late-stage financing rounds, as these transactions are favored and understood amongst professional investors. As a company matures, it becomes necessary for its performance metrics and financial health to be used to settle on a valuation. Equity is the most common way for private companies to raise capital from investors. However, priced equity rounds can incur significantly more legal expenses so entrepreneurs must budget accordingly in order to successfully raise equity capital.

Debt securities are favorable to entrepreneurs who want to raise capital but retain ownership in their company. Debt capital must be used sparingly and in connection with strong financial health. This type of security can potentially yield a better cost of capital but must be able to be serviced using the company’s cash flows.

How Zest can help

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