It can be difficult for startup companies to raise capital. The good news, however, is there are a number of investment vehicles available to steer them toward success. By understanding all their options, startups and early stage companies can make the best decision for their current needs and future. Let’s dive deeper into the various types of investment instruments that exist.
Simple Agreement for Future Equity or SAFE notes were founded in 2013 by Y Combinator, a Silicon Valley startup accelerator. Even though SAFE notes are designed to be converted to equity at a later date, they’re not loans. As a result, they lack an interest rate and maturity date. Startups don’t have any pressure to convert SAFE notes into equity at a specific date or fundraising round.
Essentially, SAFE notes are agreements or warranties. These investment vehicles fall into several categories, which are based on whether they include or exclude a discount rate and valuation cap. A discount rate refers to a percentage off in the next round while a valuation cap places a maximum ceiling on the valuation of the next round. Here’s a brief overview of the four types of SAFE notes.
- Discount Included; Valuation Cap Included: Since it offers two incentives, this version is quite popular. If the SAFE converts above the valuation cap, SAFE investors buy in at the lower dollar per share established by the valuation cap. On the flip side, if the SAFE converts below the valuation cap or if the discount provides a better price, SAFE investors buy in at the lower dollar per share established by the discount.
- No Discount; Valuation Cap Included: This version offers the benefit of a valuation cap, but doesn’t include the discount rate, which is used if the SAFE converts below the valuation cap.
- Discount Included; No Valuation Cap: Discount included, no valuation cap removes the valuation cap, but provides a discount upon conversion. It guarantees that investors get extra value upon conversion.
- No Valuation Cap; No Discount: This version is the least common as it offers no incentive for investors and is far harder to sell. However, it may make sense if the primary goal is to minimize dilution.
Convertible notes are similar to SAFE notes in that they’re designed to be converted into equity at a later date. However, they differ in that they’re considered debt instruments with an interest rate and a maturity date. In general, convertible notes have a discount rate upon conversion. The main components of convertible notes include:
- Interest Rate: Since convertible notes are similar to traditional debts, they have an interest rate. Interest is usually accrued, but not paid in cash to investors. Both the principal and accrued interest are converted into equity. This allows investors to enjoy more shares when the note converts than they would've from their initial principal investment.
- Maturity Date: A maturity date is required as convertible notes are debt instruments. The startup must convert notes into equity by the maturity date or change the maturity date via a legal process.
- Discount Rate: Convertible notes also consist of a discount rate, which allows investors to convert their principal and interest into equity at a discounted price.
- Valuation Cap: In addition, convertible notes may feature a valuation cap. which sets the ceiling on the valuation of the company. In other words, there is an upper limit on the price investors are willing to pay for each share of the company.
SAFES vs. Convertible Notes
While SAFEs and convertible notes are similar in nature, there are several notable differences between them, including:
- Debt Classification: Unlike SAFE notes, convertible notes are classified as debt instruments. Convertible notes, which are also known as convertible debts are loans that must be paid back through cash or company shares.
- Interest: Just like most debts, convertible notes charge interest. A business will need to repay the principal they borrow plus interest. SAFE notes, however, don’t carry interest because they act as agreements or warranties.
- Timing: Convertible notes come with a maturity date whereas SAFE notes do not. After a period of about 18 to 24 months, a convertible note usually converts automatically or must be repaid. SAFE notes can be held if a business stops raising funds.
- Documentation: Compared to convertible notes, SAFE notes are usually simpler and shorter. They involve less terms and contingencies for a business and investors to agree on. Also, convertible notes typically require a separate note purchase agreement while SAFEs do not.
- Flexibility: SAFEs are based on standardized templates that are readily available on Y Combinator’s website. While convertible notes might allow for more flexibility for business and investors, they require greater legal assistance to produce.
Also known as Keep It Simple Security notes, KISS notes are agreements between investors and startup companies. They were designed to standardize the seed funding process and make it easier for startups.
Here’s how a KISS note works: Once the investor invests money, they receive the right to purchase shares in a future equity round. A KISS note is a hybrid between a SAFE and convertible note because it offers the simplicity of a SAFE but adds the investor protections of a convertible note.
KISS, which has been around since 2014, was created by 500 Startups, an early-stage seed fund and incubator with a focus on small to medium sized internet startups. There are two types of KISS notes, including:
- Debt KISS notes: The debt version features an interest rate and maturity date. The investor can convert the investment into preferred stock after an agreed upon date, which is usually 18 months. It resembles a convertible note.
- Equity KISS notes: An equity KISS note doesn't come with an interest rate and maturity date. Once the business raises funds in a “priced” round, which is typically $1 million, the KISS note automatically converts to preferred stock. Since a KISS note doesn’t accrue interest or feature a repayment clause at maturity, it tends to be the most attractive option for many startups.
Special Purpose Vehicles (SPVs) are legal entities that are created for one particular purpose. Typically, they’re formed as limited liability companies (LLCs) or limited partnerships and considered pass-through vehicles. This means they’re owned by their members and pass through income or losses to those members, in proportion to the ownership each member has.
When a limited partner invests in an SPV, they officially become a member of it. In exchange for their capital, they receive membership interest, which is usually expressed as a percentage. Let’s say a limited partner invests $10k into an SPV. If the SPV raises $100k total, they’ll receive 10% membership interest in it.
As soon as an SPV is done raising capital, it makes a single investment in a startup and sends one wire transfer to it. Then, it appears as a single entry on the company’s cap table, which is a document that outlines ownership.
Just like typical venture funds, SPVs may charge carried interest and management fees. However, all capital is usually paid upfront instead of several times throughout the life of the fund. It’s important to note that each SPV is unique and has its own features, such as hurdle rates, waterfall provisions, distribution timings, and redemption rights.
There’s no denying that finding the right combination of investment vehicles is tricky. But by comparing all of the options out there and weighing their pros and cons, startups can determine the right ones for them.
Are you a startup founder looking to raise capital? Sweater is always looking to invest in innovative companies. Reach out to us at https://www.sweaterventures.com/contact or download the Sweater app today!
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I'm an expert in startup financing and investment instruments, with a deep understanding of various options available to early-stage companies. My expertise is demonstrated through first-hand knowledge and a comprehensive understanding of the concepts mentioned in the article you provided.
Now, let's delve into the different investment instruments discussed in the article:
SAFEs (Simple Agreement for Future Equity):
- Overview: SAFE notes were introduced in 2013 by Y Combinator. They are not loans but agreements or warranties designed to convert into equity later.
- Types of SAFE Notes:
- Discount Included; Valuation Cap Included: Popular for offering two incentives – a discount rate and a valuation cap.
- No Discount; Valuation Cap Included: Provides a valuation cap but lacks a discount rate.
- Discount Included; No Valuation Cap: Offers a discount upon conversion without a valuation cap.
- No Valuation Cap; No Discount: Least common, as it provides no incentives for investors.
- Similarities with SAFE Notes: Designed to convert into equity later, but differs as they are considered debt instruments with an interest rate and maturity date.
- Interest Rate: Accrued interest is not paid in cash but converted into equity.
- Maturity Date: Conversion must occur by this date.
- Discount Rate: Allows conversion at a discounted price.
- Valuation Cap: Sets a ceiling on the company's valuation.
SAFEs vs. Convertible Notes:
- Debt Classification: Convertible notes are classified as debt instruments, unlike SAFE notes.
- Interest: Convertible notes charge interest; SAFE notes do not.
- Timing: Convertible notes have a maturity date, while SAFE notes can be held without a specific timeline.
- Documentation: SAFE notes are usually simpler; convertible notes require more legal assistance.
KISS Notes (Keep It Simple Security):
- Overview: Agreements between investors and startups, aiming to standardize the seed funding process.
- Debt KISS notes: Feature an interest rate and maturity date, convertible to preferred stock.
- Equity KISS notes: Convert automatically to preferred stock after a priced funding round.
SPVs (Special Purpose Vehicles):
- Overview: Legal entities created for a specific purpose, often formed as LLCs or limited partnerships.
- Function: Pass-through vehicles owned by members, with members receiving membership interest.
- Investment Process: SPV raises capital, makes a single investment in a startup, and appears as a single entry on the cap table.
- Choosing the right combination of investment vehicles is challenging.
- Startups should weigh the pros and cons of each option to determine the best fit for their needs.
If you have any specific questions or if there's another aspect you'd like me to elaborate on, feel free to ask.