Founders’ Toolkit – Choosing The Right Fundraising Method

After formation, most founders face the same question: how do I inject cash into the company? The answer depends on your stage, your goals, and how much complexity you are willing to assume. This installment of the Founders’ Toolkit provides a high-level overview of the three primary fundraising methods available to early-stage, venture-backed startups: convertible notes, SAFEs, and equity financing rounds.

1. Convertible Notes

A convertible note is a debt instrument through which an investor lends money to your company. The principal and any accrued interest will convert into preferred stock upon a “Qualified Financing,” which is typically a bona fide financing round where the company issues preferred stock or raises a specified dollar amount. Most convertible notes have a term of 12 to 24 months, during which interest accrues, and at maturity the note is either repaid with interest or converts. Because the investor is taking an early risk on the company, the investor receives a discounted price per share upon conversion, calculated using (i) a valuation cap, (ii) a discount rate, or (iii) a combination of both, with the investor receiving whichever yields the lowest price.

Convertible notes offer significant drafting flexibility, because there is no standard market form, and they allow companies to raise capital without immediately diluting existing shareholders or granting investors voting rights. On the other hand, notes are debt, meaning they accrue interest, carry a maturity date requiring repayment, and sit senior to equity in a dissolution or liquidation event.

2. SAFEs (Simple Agreements for Future Equity)

SAFEs function similarly to convertible notes in that the discounted price per share upon a future financing event is determined using a valuation cap, a discount rate, or a combination of both; however, there are key differences. Y Combinator maintains standardized SAFE forms that the industry has accepted as market, meaning these agreements can be more efficiently negotiated. SAFEs are generally recognized and treated as equity for U.S. federal income tax purposes, so an investor’s Qualified Small Business Stock (QSBS) holding period would start at the time the SAFE is issued rather than at conversion. Unlike convertible notes, SAFEs do not have a maturity date and do not accrue interest, and repayment is required only upon a liquidation or dissolution event, reducing pressure on cash-strapped founders.

The tradeoff is simplicity itself. SAFEs are intentionally bare-bones instruments. If you or your investors want detailed rights and protections, or if you need to raise larger sums of capital, an equity financing round may be the better path.

3. Equity Financing (Preferred Stock)

When larger amounts of capital are being raised, a priced equity round issuing preferred stock is often the best approach. Preferred stock carries innate benefits over common stock, including a liquidation preference, dividend preference, protective provisions requiring preferred holder consent for certain corporate actions, and anti-dilution protection. Investors meeting a “Major Investor” threshold oftentimes receive contractual rights such as information rights, inspection rights, preemptive rights, and rights of first refusal and co-sale.

The primary benefit of a priced round is certainty: actual shares are issued at closing, so everyone knows exactly how the financing affects ownership. Investors also benefit from QSBS holding periods that commence immediately upon issuance. The National Venture Capital Association maintains form documents, which are widely accepted as market, providing a recognized starting point for negotiations.

The downside is cost and complexity. Equity rounds are the most expensive and time-consuming fundraising method for companies, as they involve due diligence and more extensive legal agreements. Furthermore, they immediately dilute existing shareholders, and they grant investors voting and governance rights from day one.

The Bottom Line
There is no universally right answer. Convertible notes offer flexibility but carry debt risk. SAFEs can be fast and inexpensive, but are intentionally simple. Equity rounds provide certainty and investor protections, but come at a premium in legal fees and immediate founder dilution. The best approach depends on your individual facts and circumstances, and any well-versed startup attorney will walk you through these considerations before you begin investor discussions. Use this framework to make informed decisions, and lean on your counsel to ensure you are raising capital on terms that position your company for long-term success.

Originally published by Gildre Newsletter.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.