Assessing Venture Capital Financing Strategies.
Under a Stock Purchase Agreement, the investor receives newly issued shares in exchange of capital that will be deployed by the company.
Issuing stocks is for many founders the most natural route to pursue, especially for those low margin and high burn rate startups whose cash flow projections are typically difficult to derive, making them the most undesirable client for the standard financial institution
Stock Purchase Agreements are secured from angel investors or venture capital firms willing to gain exposure to startups whose growth potential is basically uncapped. Selling equity means there is no set payment schedule for the investor whose goal is to realise a sustainable return after a future liquidity event, called “exit”, that can take place through a takeover or an Initial Public Offering.
There are two forms of equity that a startup company can issue: common stock and preferred stock. Preferred stock generally has significant rights that common does not have. Specifically, preferred stock protects investors in scenarios such as sales of new or existing preferred stock, change of control, or liquidation events. This happens thanks to rights such as liquidation preference, participation rights, pre-emption rights, right of first refusal, co-sale rights, and redemption rights.
Talking specifically about early-stage startups, there are generally two classes of people receiving shares: founders and investors. Founders typically receive common stock. Investors, on the other hand, generally receive preferred stock. It is indeed worth noting that the allocation of proceeds of a startup depends both on the percentage of the company held and the specific rights associated with the shares held. Because preferred stock often features rights that confer economic preferences as compared to common stock, the specific features of the preferred stock issued by a company can significantly impact the allocation of proceeds in a liquidation scenario. In certain cases, common shareholders may be left with little or no returns after the required payments to preferred shareholders, especially in cases with participating preferred stock or multiple liquidation preferences. So, overall, preferred stock appears as a more appetible solution for investors who wish to reduce the risk of their investment in a new venture.
In the table below we summarize the advantages and disadvantages of equity fundraising from both funders and investors perspectives.
A convertible note is a short-term note that converts into equity. Convertible notes operate as loans and are typically issued in conjunction with future equity rounds
The main reason why founders go for Simple Agreement for Future Equity (SAFEs) or convertibles described before, is because of the priority in liquidation rights compared to preferred stock. Also add that there is no interest payment during the contract but accrued until maturity when normally there is a conversion. Valuation cap and valuation discount must both be there to safeguard the investor. Founders that expect their company to gain a much higher valuation in a few months time can bridge by issuing Convertibles or SAFEs to get money quickly and then if what they promise happens they convert the notes into equity and the investor receives more shares given the discount and valuation cap. The valuation cap is the most important term of a convertible note or a SAFE, as it sets the maximum price that the convertible security will convert into equity.
For situations where companies do not want to set an equity valuation (to not impede subsequent financings from other investors), or they simply want the option of potentially paying back the cash, a convertible note is the way to go.
A convertible note is a hybrid, part debt and part equity: it functions as debt, until some point in the future, when it may convert to equity at some predefined terms. The most common method of conversion occurs when the equity investment exceeds a certain threshold (qualified financing). This form of financing is usually used for smaller rounds of financing at the early stages of a company’s life.
When the convertible notes convert to equity in the event of a qualified financing, not only do the note holders get credit for both their original principal plus accrued interest to determine how many shares they receive, they also generally get a discount to the price per share of the new equity.
In the table below we summarize the advantages and disadvantages of convertible notes from both funders and investors perspectives.
A SAFE or safe stands for a “simple agreement for future equity”.
In practice a SAFE enables a startup company and an investor to accomplish the same general goal as a convertible note, though a SAFE is not a debt instrument. It is an agreement that can be used between a company and an investor. In exchange for the money, with a SAFE, the investor receives the right to purchase stock in a future equity round (when one occurs) subject to certain parameters set in advance in the SAFE. It is also an extremely simple investment instrument compared to other forms of financing; it doesn’t carry an interest rate and doesn’t have a maturity date.
In the table below we summarize the advantages and disadvantages of SAFEs fundraising from both funders and investors perspectives
A mathematical approach to pick the best choice between equity and convertible/SAFE
This part of the report is based on the Power Law Model for Valuation Cap explained in more detail by Timothée Le Page.
Consider an investor that faces two possibilities for an investment in a start-up.
Participate in a capital increase (preferred shares) for an amount at a set Valuation Pre-Money (t=0)
Subscribe a convertible note for a Nominal Amount (t=0), with a discount [s, S = 1- s], an interest rate (r) and a Valuation Cap .
Let t=t be the time of conversion of the convertibles, and t=0 the date convertibles are subscribed. We note [NOSH (t=0)], the number of outstanding shares before the equity round. Setting aside the benefit of the convertibles in case of liquidation (higher priority in case of company liquidation which makes the convertibles more valuable than equity), no-arbitrage principle dictates that the investor must be indifferent between convertibles and equity shares, since in fine, he gets the same financial instruments (i.e., shares).
If all other parameters are fixed (r, s, t, Valuation Pre-Money (t=0)), is the variable that must equal the returns between the two securities. This implies that there must be a minimum valuation cap.
Let’s do backward induction. If the investor knows the pre-money valuation at maturity, he can without hesitation choose between the two financial instruments. Below a certain terminal valuation, for a certain discount, interest rate, and time of conversion, the investor always prefers convertibles, since he has the accrued interest and the discount, while he does not convert for a valuation far above the current value. After a certain threshold, without valuation cap, he always chooses equity, as he converts at a valuation so high that even the debt perks are not enough to offset the difference.
Valuation cap should at least be above the immediate gain from taking on the convertibles. Which means that the pre-money valuation must be below a maximum threshold given a valuation cap. Otherwise, the investor always prefers to go convertibles.