03. Investment Instruments

Startup investing instruments refer to the different methods that investors can use to provide funding to a startup in exchange for equity or ownership in the company.

Three common startup investing instruments are convertible notes, SAFEs, and priced rounds.

Overall, convertible notes and SAFE agreements are often used by startups and early-stage companies as a way to raise funds without having to undergo a full valuation process. Priced rounds are typically used when a company is further along and have a set valuation.

  1. Convertible Notes: A convertible note is a type of debt instrument that can be converted into equity at a later date. It is essentially a loan to the company that is meant to convert into equity upon a future financing round. A convertible note will typically have an interest rate, a maturity date, and a conversion discount or valuation cap that allows the investor to convert their debt into equity at a favorable price when the company raises its next round of funding.

      2. Terms that can be negotiated by the investor or founder:

    1. Interest rate: The interest rate on the loan is negotiable and can vary depending on the stage of the company and the perceived risk of the investment.
    2. Maturity date: The maturity date of the note is negotiable and can range from a few months to a few years.
    3. Conversion discount: The conversion discount allows the investor to convert their debt into equity at a discounted price compared to the price paid by the next investors in the company’s next financing round.
    4. Valuation cap: A valuation cap sets the maximum price at which the debt can be converted into equity.

      5. Pros:

    5. Simplicity and speed of execution
    6. Minimal negotiation required
    7. No need to value the company at the time of investment

      8. Cons:

    8. Dilution to existing shareholders is uncertain
    9. If the company doesn't raise equity before the maturity date, they will owe the interest

  1. Simple Agreement for Future Equity (SAFEs):

      2. A SAFE is a relatively new financial instrument created to simplify early-stage startups' investment process. Y Combinator created a version of the SAFE that is now considered the standard.

      It is similar to a convertible note, but instead of a loan, the investor makes a cash investment in exchange for the right to receive equity in the future.

      The key terms that can be negotiated by the investor or founder include:

    1. Valuation cap: This sets the maximum valuation at which the investor can receive equity in the company. This protects the investor from being diluted if the company's valuation increases significantly.
    2. Discount rate: This is a percentage discount that the investor receives when they receive equity in the company. This discount compensates the investor for the risk they take by investing in an early-stage company.
    3. Conversion events: These are events that trigger the conversion of the SAFE into equity. This can include an IPO, acquisition, or a subsequent financing round.

      4. Pros:

    4. Simplicity and speed of execution
    5. Minimal negotiation required
    6. Can be less dilutive than a convertible note

      7. Cons:

    7. Dilution to existing shareholders is uncertain
    8. Fewer protections for investors compared to a priced round

  1. Priced Rounds:

      2. A priced round is a financing round where the company sells equity to investors at a pre-determined price per share. This means that the investor is purchasing a percentage of the company's equity at a specific price.

      The key terms that can be negotiated by the investor or founder include:

    1. Valuation: This is the price per share that the investor pays for the equity. The valuation can be negotiated between the investor and the founder.
    2. Liquidation preference: This determines the order in which investors are paid in the event of a liquidation event, such as an acquisition or bankruptcy. Today’s standard liquidation preference is 1x.
    3. Anti-dilution provisions: These provisions protect the investor from being diluted if the company issues additional equity at a lower price than what the investor paid.

      4. Pros:

    4. Clear valuation of the company
    5. More protections for investors than convertible notes or SAFEs
    6. Allows for participation in the company's future growth through ownership of equity

      7. Cons:

    7. More complex and time-consuming than convertible notes or SAFEs
    8. Requires negotiation of terms and price per share
    9. Typically incurs more legal fees