It’s a common question for new angel investors: Why not invest and get equity immediately in new startup companies?
In short, it’s difficult for an investor to value startup companies with little to no operating history. While the valuation of a startup is a key part of the investment process, jumping straight to priced rounds for early-stage startups can create challenges for the investor and the startup alike, because valuations can be under or overpriced. Underpricing hurts the company by giving away an excessive amount of ownership to new investors and unfairly diluting older investors. An overpriced startup is unfair to investors because it results in lower than expected investment returns. Pricing is difficult because there is little to analyze since startups are light on cash flow, light on assets, and mostly long on founder enthusiasm. New technologies, like Fundr’s proprietary algorithm, help investors assess a startup’s potential. It’s then up to the investors to invest in or pass on the company’s future prospects. Still, on our Fundr platform, we suggest investors avoid a priced equity round and use a convertible note. Convertible securities give the company and investors time to find clarity on valuation.
A priced round is done with equity and it is pretty straightforward to understand. However, there are two other popular securities, convertible notes and SAFE notes, which tend to be more complex. We discuss all three securities below:
Despite the challenges of early-stage valuation, equity is still a popular investment instrument. When investors purchase equity in a startup company, they become shareholders and owners of the company.
Pros: When equity is issued, both the investor and the startup agree on the value of the company - leaving no surprises for either party. Issuers do not need to repay the principal investment, however, investors gain some control over the company.
Cons: For the investor, excessive dilution tends to be a downside of equity funding. Investors may lose proportional ownership in the company with future rounds of equity funding. For, startups the downside is yielding ownership and control when issuing equity.
Convertible notes are debt instruments that provide investors with an extra layer of protection while waiting for the debt to be paid or converted into equity.
Pros: Usually the conversion from loan to equity happens if specific criteria are met, like a round of qualified financing (which is fancy legal talk for a future funding round of a predetermined amount). Convertible notes also allow for early exit payback, so if the notes are paid early and before conversion the conversion date, then investors are entitled to receive more than their investment principal and associated interest. In addition, until it converts the note is a debt instrument, which provides the investor with all the rights of a debtor.
Cons: While the debt feature is advantageous for note investors, it’s a disadvantage for founders and other equity investors because in the case of liquidation by bankruptcy, debt holders are paid before equity holders.
Simple Agreement for Future Equity, also known as SAFE notes are similar to convertible notes in that they are contracts between investors and startups that eventually give investors equity in the startup. The main difference is that SAFE notes are not debt instruments and there is no need to do accrued interest math.
Pros: Like convertible notes, SAFE notes change to equity during a future round of equity financing, usually when preferred shares are issued. For startups, SAFE notes provide a cash infusion into the business. Like convertible notes, SAFE notes also allow for early exit payback but do not include accrued interest since there is no debt instrument involved.
Cons: Because SAFE notes are not debt instruments, investors have little protection during a liquidation event caused by bankruptcy. And, since there is no conversion date there is uncertainty around when and if a conversion to equity will occur.
Both convertible notes and SAFE notes are popular investing instruments for angels because they allow investors and startups to think about valuation as a longer-term dimension of the business’ success, rather than defining value in the early years of a venture. On the other hand, equity remains a strong investment option for investors who have strong confidence in a startup, and want to have part ownership of the business at the early stages.
Stay tuned for Part 2 of Fundr Facts, where we discuss certain terms and provisions of Fundr’s Convertible Note. Sign up today to automate your investing process at www.fundr.ai.