Convertible Debt/SAFE vs. Equity
Transcript
Welcome back. I hope everybody had a great holiday season and is geared up for this new year. And because it's the first of the year, we'll talk about your first round of funding.
So first real round of funding. You know, most entrepreneurs start out with bootstrapping their own, putting their own money in. Sometimes they get a little friends and family money in.
But then it's time to take outside capital in. And that's what we're going to talk about today. When you take that outside capital in, you have to think about the structure of the deal.
and you basically have two choices. One choice is either a convertible debt or safe. I lump them
together because structurally they're very, very similar. There's some subtleties, but they're
really similar. Or a priced round, which some people refer to as an equity round.
On the surface, it seems like convertible debt or safe is the easiest way to go.
And it is. It's much less expensive in legal fees than doing a priced round. You can do what's
called a rolling close, that's amazing. That means as soon as the first person says yes, you can take
his or her check, deposit it, have some paperwork signed, a couple weeks later get the next check,
the next check. You don't have to wait to turd all the cats and get it all coordinated. You see,
when you do a price round or an equity round, you typically have a closing. You wait until everybody
agrees. Everybody agrees on the terms. They all sign the documents at the same time. They all fund
at the same time. Oh, and then there's that pesky thing called valuation. You see, with a price
round, you have to specify exactly how much people are paying for their shares of stock, what the
pre-money and post-money valuation of the company is. With convertible debt or safe, you don't really
have to do it. Sometimes they don't have any cap at all, any reference to valuation. Most of the
time they have what's called a valuation cap. My equity will convert in the future at a price not
to exceed X. That seems great, but there's a problem with all of this, and that is that
you're mortgaging today at the expense of tomorrow. And I like to do the opposite. In
business I have a philosophy that we should always be striving to make tomorrow better
than today. And so you don't always see the real cost of doing this convertible debt or
safe round. Let me give you an example. Imagine you were going to go bake a cake and you went
to the grocery store and you wanted to buy some sugar. And you gave the clerk some money and the
clerk said, oh, I'll give you some sugar at some point in the future. I'm not really going to tell
you how much sugar and I'm not going to tell you when. You'll just get some at some point in the
future. That would not be a very good transaction. You wouldn't walk away from there feeling good.
Yet that's what entrepreneurs are asking investors to do when they ask them to invest in convertible
debt or safes. Give me some money today for a promise that in the future I'm going to give you
some equity. I can't tell you how much. I can't tell you the terms of that equity. And I can't
tell you when I'll deliver it. There is a lack of clarity in that transaction. And because of that
lack of clarity, it has some implications down the road that we're going to talk about next week
and how they can potentially make your next round much more difficult to close.
But if you do the same transaction today and use a priced round or equity structure,
you have to do a little bit more work and have a little bit more expense,
but now you're making next year, you're making tomorrow better. Everybody knows exactly where
they stand. They know how much they paid, how many shares of stock they got, and what percentage of
the company that represents. They understand the terms of that stock. Is it participating
preferred, convertible preferred? Is there a dividend? Is there a preferential return? All
of those things are spelled out in the documents. They understand the structure of the board of
directors, who's on it, what control they have, protective provisions, etc. And it's really
important for you as the entrepreneur to have this clean structure for two reasons. One is,
as I said, it will make fundraising your next round much easier. But two is, it's important for
you on your growth trajectory to start exercising that muscle, to start showing future investors that
you have the rigor, you have the structure, you have the board of directors, that you know how
do this. So in most cases I believe that choosing a priced round or equity over
the simpler convertible debt and safe will make tomorrow much better for you
and your company.
When you are raising your first round of capital you basically have two options, SAFE/Convertible Debt or Equity. One option may seem to offer more flexibility and lower cost, but the other will be much more beneficial in the long run. Show your investors you know what you are doing and do the hard work up front and you will benefit in the long run!
Originally published on the MATH Venture Partners blog.