Understanding Startup Investments
Chapter 4
Convertible securities are a type of investment set up to later convert into a different type of investment.
As applies to startup investing, convertible securities can generally fall under two umbrellas:
Early-stage startups sometimes will raise money via convertible securities if they’re not ready to firmly establish their valuation, or are between rounds of funding, and need to raise money relatively quickly. Therefore, the investors use convertible securities to essentially buy time until a priced equity round occurs, which will inform how the investment amount translates into shares in the company.
EXAMPLE
In June 2004, “The Facebook” was picking up traction and running on fumes. Mark Zuckerberg and his co-founders moved the fledgling social media site from Zuck’s Harvard dorm room to Silicon Valley, where they teamed up with Sean Parker, dropped the “the”, and started their search for funding.
It didn’t take long for Parker to convince eBay founder, Peter Thiel, to take a bet on Facebook.
Peter Thiel [invested $500,000](http://dealbook.nytimes.com/2012/02/01/tracking-facebooks-valuation/?_r=0) in Facebook’s Seed Round via a convertible note. His investment converted into a [10.2% equity stake](http://whoownsfacebook.com/#Thiel) after Facebook’s $12.7 million Series A round in 2005. Assuming a [$100 million post-money](http://dealbook.nytimes.com/2012/02/01/tracking-facebooks-valuation/?_r=0) Series A valuation, Thiel’s $500,000 investment then converted into $10.2 million of equity in Facebook.
Convertible securities come with other benefits, in addition to allowing startups to defer establishing valuation. Rounds with convertible securities typically close more quickly than priced equity rounds and are less expensive to execute, as they require less legal and compliance overhead. Priced equity investment agreements comprise around 300 pages of legal documentation, vs. the 5-6 page convertible security documents.
Convertible securities often close on a rolling basis. Investors wire money to the startup as they are ready to sign and close (send money), whereas, during a priced equity round, all investors will usually close on the same day, requiring more time and coordination to get all parties on the same page.
On the investor’s side, investing via a convertible note can come with benefits to balance out the risk of investing early-on, like discounted shares, and the opportunity to invest in the company early-on and help to shape its growth. Convertible securities also give investors access to startups that may be nearly impossible to invest in later on. Later funding rounds tend to become especially competitive for promising startups.
Convertible debt is a type of convertible security that is structured similarly to a loan; these securities accumulate interest, have a set maturity date, and are issued with clearly defined terms.
But, unlike your student loans, startups aren’t actually expected to repay convertible debt. Instead, the amount of the loan, plus interest, is set to convert into equity in the company at a defined point in time, and according to certain pre-defined parameters.
The most commonly used convertible debt vehicle for early-stage startup investing is a convertible note.
Convertible notes are a type of convertible debt instrument commonly used to fund early and seed stage startups.
Startups often choose to raise funding via convertible notes if they are not ready to establish valuation, or expect valuation to change dramatically in the next round, but need or want an influx of cash before the next priced round.
Convertible Notes are just one way of investing in a company while legally structuring the investment as debt.
Before the SAFE was created, structuring early-stage investments as debt instruments was a popular “shortcut” startups could use to raise financing quickly, without actually putting a value on the company.
Now, many startups will raise money via SAFEs so they can avoid some of the aspects of debt that are more burdensome for young companies (like interest rates or maturity dates).
Y Combinator developed the SAFE, “Simple Agreement for Future Equity,” a short document used to organize convertible equity funding, as an extremely simple funding agreement that caters to both founders and investors.
SAFE documents function similarly to convertible notes, but they are not debt vehicles – meaning that the investment amount is set up to convert into equity at a predefined point, and there is no expectation that the startup will repay the amount of the investment.
When an investor invests in a startup via a SAFE, he or she receives the right to purchase stock worth the amount of his or her investment a future equity round (when one occurs) subject to certain parameters dictated in the SAFE.
Like convertible notes, SAFEs are often issued with caps, discounts, and on rare occasions, most favored nation clauses. However, SAFEs do not contain a maturity date, or accrue interest.
SAFEs solve a number of issues that convertible notes pose for startups and investors:
In addition to convertible notes and SAFEs, 500 Startups KISS documents are also used to fund startups, though less often than equity funding, convertible notes, and SAFEs.