When do priced rounds typically happen for startups?

Priced rounds are still the primary way startups raise money, but they are no longer the first fundraising event. They typically occur after a startup has used convertible securities like SAFEs or convertible promissory notes for initial funding.

What are the main challenges with using convertible securities in startup funding?

Challenges include difficulty in tracking exact ownership dilution because convertible security holders aren't yet stockholders, and the potential to accumulate too many investors (a 'party round'), leading to administrative complexity for future consent.

Can a company just keep raising money using SAFEs and never do a priced round?

While theoretically possible, it's exceedingly rare for a company to never need future funding, a sale, or an IPO. Founders also need liquidity, which usually comes from these exit events or further financing rounds.

What is the key term to negotiate when using a SAFE?

The primary term to negotiate for a SAFE is the valuation, specifically the valuation cap or target valuation. While other terms can be added, the SAFE was designed to be simple with minimal negotiation points.

Should startups in Boston avoid using SAFEs if investors are unfamiliar?

While West Coast investors are very familiar with SAFEs, it's recommended to approach with SAFEs due to their speed and flexibility. However, be prepared to educate investors or discuss alternative instruments like convertible promissory notes if they are hesitant.

What happens if a company never converts its SAFEs because it never does a priced round?

The SAFE is designed to convert upon a priced round, sale, or IPO. If none of these occur, it's a 'corner case,' but companies generally need subsequent funding rounds for growth, or founders seek liquidity through an exit.

Key Moments

Carolynn Levy - Modern Startup Funding

Y Combinator

Science & Technology5 min read29 min video

Sep 20, 2019|88,946 views|1,737|45

YC Y Combinator Startup School

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TL;DR

Modern startup financing uses convertible securities like SAFEs, simplifying early-stage fundraising compared to traditional preferred stock rounds.

Key Insights

Early-stage startup financing has evolved significantly, moving from complex preferred stock rounds to simpler convertible securities.

Convertible securities, such as SAFEs and convertible promissory notes, are designed to streamline fundraising, reduce legal costs, and save founder time.

SAFEs (Simple Agreement for Future Equity) are a debt-free alternative to convertible promissory notes, offering a faster and more flexible way to raise initial capital.

While convertible securities simplify initial fundraising, priced equity rounds remain crucial for later-stage funding and are where convertible securities eventually convert.

Key considerations for founders include understanding valuation and dilution, especially as convertible securities convert into equity during priced rounds.

Effective communication with investors is paramount throughout the startup lifecycle, regardless of the financing method used.

THE EVOLUTION OF STARTUP FINANCING

The landscape of startup financing has undergone a dramatic transformation over the years. Historically, early-stage fundraising involved complex and time-consuming preferred stock rounds. However, innovations, largely driven by organizations like Y Combinator, have introduced more streamlined methods. This evolution is marked by changes in the structure of financing documents, increased accessibility to these documents, and a greater focus on efficiency to allow founders to concentrate on building their companies rather than getting bogged down in lengthy fundraising processes.

TRADITIONAL VS. CONVERTIBLE SECURITIES

Traditionally, the first significant fundraising event for a startup was a Series A preferred stock financing. This involved intricate negotiations, substantial legal fees (often $25k-$100k), and a lengthy process that could take months. The core issue was its inflexibility, especially as the cost of starting software and e-commerce companies decreased, making large minimum raises unnecessary. This led to the rise of convertible securities like convertible promissory notes, which offered a simpler, faster, and cheaper alternative for initial funding.

THE RISE OF THE SAFE (SIMPLE AGREEMENT FOR FUTURE EQUITY)

Building upon convertible promissory notes, Y Combinator developed the SAFE (Simple Agreement for Future Equity). Unlike promissory notes, SAFEs are not debt instruments; they do not accrue interest or have maturity dates. This debt-free structure is ideal for both investors, who want to participate in equity growth rather than act as lenders, and founders, who want to avoid the complexities of managing debt. SAFEs are designed to be simple, easily accessible online, and require minimal negotiation, typically focusing on valuation.

THE ROLE AND MECHANICS OF CONVERTIBLE SECURITIES

Convertible securities, including SAFEs and convertible promissory notes, represent a right to receive stock in the future. They are essentially placeholders that convert into equity during a subsequent priced round of financing. The primary appeal is their speed and simplicity compared to a full preferred stock round. While they allow startups to raise capital quickly and affordably, founders must be mindful of the eventual conversion and its impact on dilution, keeping track of ownership percentages as these instruments convert into actual shares.

THE CONTINUED IMPORTANCE OF PRICED ROUNDS

Despite the prevalence of convertible securities for initial fundraising, priced equity rounds remain the primary mechanism for later-stage investment. These rounds are essential because they establish a definitive valuation for the company, at which point convertible securities convert into preferred stock. While priced rounds themselves have become more standardized and accessible online, they still involve significant documentation and typically require legal counsel. They represent the 'day of reckoning' where the true ownership stakes are finalized after initial convertible investments.

CONSIDERATIONS AND CHALLENGES WITH MODERN FUNDRAISING

While modern financing methods are more efficient, founders must still navigate potential challenges. Dilution is a key concern; as convertible securities convert, founders' ownership stakes decrease. Additionally, the ease of raising smaller, custom amounts can lead to a 'party round' with numerous investors, creating administrative complexity. Investors in convertible securities may also be less engaged than those in priced rounds, potentially impacting their involvement in providing strategic advice or making introductions. Founders need to manage these aspects alongside the core business.

EDUCATING INVESTORS AND NAVIGATING DIFFERENT REGIONS

The adoption of modern financing tools like SAFEs can vary by region. While common on the West Coast (e.g., Silicon Valley), investors in other areas, such as Boston, might be less familiar with these instruments. Founders may encounter investors who prefer traditional convertible promissory notes or even direct preferred stock investments. In such cases, founders may need to invest time in educating potential investors about the benefits of SAFEs and convertible securities to facilitate fundraising, emphasizing their efficiency and alignment with startup growth.

KEY TERMS AND NEGOTIATION IN SAFES

When using a SAFE, the primary term to negotiate with investors is the valuation cap. This cap sets the maximum valuation at which the SAFE will convert into equity during a future priced round. While there are versions of SAFEs that do not include a valuation cap, negotiating this term is crucial for determining future dilution. Beyond valuation, SAFEs are designed to minimize negotiation, eliminating the need for extensive legal review and reducing associated costs, aligning with their goal of simplifying early-stage fundraising.

ADDRESSING 'CORNER CASES' IN CONVERTIBLE SECURITIES

One potential 'corner case' with convertible securities is the scenario where a company never raises a subsequent priced round. In such situations, the SAFE or convertible note may not convert as intended. While exceedingly rare, as most companies require further funding to grow or founders seek liquidity through an exit, mechanisms can be incorporated to address this. However, the core design of the SAFE prioritizes simplicity over covering every improbable eventuality, reflecting its gamble-like nature as an equity investment.

THE DECISION: CHOOSING BETWEEN CONVERTIBLES AND PRICED ROUNDS

The decision to use convertible securities or pursue a priced round depends on the specific circumstances. If a venture capital firm offers a substantial investment (e.g., $5 million) for a company's very first fundraising, a priced round might be appropriate. However, for most early-stage companies, especially those seeking smaller amounts of capital, convertible securities offer a more practical and flexible approach. The key is to ensure the chosen method aligns with the company's immediate needs, investor comfort, and careful tracking of dilution.

SERVICES-FOR-EQUITY AND THE LIMITATIONS OF SAFES

SAFEs are specifically designed for monetary investments, not for exchanging equity for services rendered. If a founder needs to compensate someone with equity for services without immediate cash payment, using a SAFE is generally not the appropriate instrument. Other methods, such as founder stock grants or agreements tailored for service providers, are typically better suited for such arrangements. This distinction highlights the specific purpose of SAFEs within the broader startup financing ecosystem.

Mentioned in This Episode

●Tools

●Organizations

●Concepts

●People Referenced

Modern Startup Funding: Key Takeaways

Practical takeaways from this episode

Do This

Form a corporation early to protect founders from personal liability.

Consider using convertible securities like SAFEs for initial fundraising.

Prioritize communication with investors about company progress.

Track dilution carefully, especially when using convertible securities.

Be prepared to educate investors in less familiar ecosystems about SAFEs.

Avoid This

Do not rely solely on selling common stock for meaningful funding.

Avoid overly long, expensive, and inflexible traditional Series A financings for early-stage companies.

Do not be surprised by dilution when convertible securities convert during a priced round.

Do not use SAFEs for equity-for-services compensation.

Do not ignore the need to eventually move to priced rounds as the company grows.

Common Questions

A SAFE (Simple Agreement for Future Equity) is a convertible security developed by YC that is not debt, designed for simplicity and speed. A convertible promissory note is a loan with an interest rate and maturity date that can convert into stock.

Topics

Business & Entrepreneurship Venture Capital Startup Funding Seed Funding Convertible Notes Equity Financing

Mentioned in this video

Organizations

SEC

Changed the rules to allow general solicitation for equity crowdfunding.

SAFE

A Simple Agreement for Future Equity, a one-page convertible security document developed by YC, designed to be simple, readily available online, and not a debt instrument.

People

Angel investors

Investors who used to aggregate into groups to write one large check for Series A financing, but now tend to write individual checks.

Concepts

Series A financing

The first round of preferred stock financing for a startup.

Convertible promissory note

A standalone document used for early-stage fundraising that functions as a loan with a mechanism to convert into stock during a future priced round.

Priced round

A type of financing round where stock is sold at a specific price per share, serving as the eventual conversion event for convertible securities like SAFEs.

Companies

Y Combinator

Provided the SAFE document online and a user guide with math examples for conversion.