An Introduction to Early-Stage Fundraising Options

When raising capital to continue funding the growth of their businesses, founders have several different options to choose from, and each has its benefits. Raising capital is vital to early-stage business growth, but it can be especially difficult if the offering to investors is not the right one. 

In order to determine which type of fundraise is right for a business, it is important to understand the differences between them, and which will be most likely to attract potential stakeholders. Not to mention, it is critical to always know how much of one’s company has been sold to investors, and therefore, how much still belongs to its founders.

Cap Table

Firstly, before raising, it is imperative to maintain a capitalization table, or “cap table,” which documents all of a company’s securities, and designates how much of those securities are owned by its founders and investors, the value of those stakes, and what percentage of the company each stake represents. Cap tables tell investors (and founders) who holds significant stakes in the company, and, if the founders hold larger stakes, can demonstrate how incentivized those founders are to make their company a success. Raising capital from investors grows the cap table, and inherently adds new stakeholders to a company. One of the most common types of early-stage fundraising vehicles is the SAFE.

SAFE

A SAFE (Simple Agreement for Future Equity) is a convertible instrument, or any type of security that can or will be converted into another security. A SAFE note constitutes an agreement between a founder and an investor in which the investor gives the owner capital now in exchange for the founder’s promise to give that investor shares in the company when that company raises capital in the future. The investor agrees to give the company a certain amount of capital at a certain valuation cap, which is the maximum valuation of the company at which an investor can convert their investment into equity. If the company raises in the future at a valuation well above the valuation cap on the SAFE, the investor benefits because their investment amount constitutes a larger stake than the same investment amount on a higher valuation (one benefit of being an early investor). SAFES may also contain a discount rate, or discount, which allows the investor to get a cheaper valuation when the company raises on a priced round. For example, if a SAFE has a discount of 20%, the valuation at which their investment will convert to equity will be 20% less than the valuation of the company on its priced round - another benefit for the investor for believing in the company early on. 

Convertible Note

While SAFE notes are a form of convertible securities, convertible notes are a type of debt that will potentially convert into equity upon the achievement of certain milestones. Like SAFE notes, convertible notes have discounts and valuation caps, but since they are a form of debt, they come with interest rates and maturity dates. In a basic lending scenario, the principal accrues interest, and the principal, plus interest, is paid back in cash later. In the case of a convertible note, this interest accrues to the principal invested, and increases the number of shares issued upon conversion from debt to equity. This issuance occurs on the maturity date, or the date when repayment of the note is due. It is important to remember that convertible notes often have both a discount and a valuation cap and convert to equity at whichever method gives the investor a lower price per share. While both SAFE notes and convertible notes are useful tools for raising capital early on, experts recommend picking one or the other before a priced round, and not both, as keeping track of the two simultaneously can result in a headache for founders and a more complex cap table. 

Priced Round

Finally, a priced round is a capital raise in which investors receive preferred shares of equity in the company based on a predetermined, fixed valuation. Contrary to SAFE and convertible notes, investors receive equity immediately upon the closure of a priced round. More commonly during priced rounds, founders find lead investors, those who invest larger amounts of capital and liaise with other investors to pitch in additional capital until the target amount of the raise is accounted for. Priced rounds, while typically providing larger total amounts of investment capital and affording longer runway for founders, also take more time and require more terms to be negotiated. SAFE notes and convertible notes typically precede priced rounds, as priced rounds establish the company’s valuation officially and allow those notes to convert to equity. When this conversion to equity happens, founders must keep in mind that dilution to their shares will occur, meaning that the percentage of the company they owned previously will decrease because they have sold shares of the company to other investors, and because the previously agreed upon notes will now convert to equity. Managing and updating a cap table is vital to understanding dilution and maintaining a concrete understanding of who owns what percentage of the company, and what that percentage is worth. 

While all of these options are valid for a founder’s first fundraise of capital from outside investors, founders should research and determine which is right for them. SAFEs generally require the least amount of negotiation, as they contain the fewest specific terms towards reaching an agreement. Meanwhile, priced rounds give founders a clearer depiction of what each stakeholder’s position is worth. 

Our team at Hyperspace Ventures has been involved in all three and enjoys discussing which is right for each founder we partner with. Send us an email at hello@hyperspaceventures.com, or submit an inquiry here!

Resources Cited

● Y Combinator 

● Carta

● Seed Invest