The Fast Track to Funding Your Startup: Convertible Notes, CCD, CCPS, SAFE
Fundraising for startups involves investors providing funds in exchange for shares or preference shares of the company. The traditional method, known as a priced round, involves negotiating an equity percentage with investors. However, early-stage companies often opt for an alternative method called a convertible instrument.
Convertible instruments offer advantages such as simplicity and speed in closing deals, allowing startups to secure funding quickly. Another benefit is that founders can maintain control and decision-making power over their company during the crucial early stages of development.
Parameters of Typical Convertible Instruments:
Convertible Notes, CCD, CCPS, SAFEs are some of the most common convertible instruments in the startup ecosystem.
These instruments come with certain parameters which are as follows:
- Valuation cap: This is the maximum price that an investor is willing to pay for a share of a startup.
- Discount: This is the percentage discount that investors receive on the valuation cap. The discount is used to incentivize investors to invest in a startup.
- Liquidation preference: This is the priority that investors have to get their money back if a startup fails. Investors with a liquidation preference will get their money back before other investors, such as founders and employees.
- Conversion period: This is the time period during which a convertible instrument can be converted into shares.
- Anti-dilution protection: This is a provision that protects investors from being diluted if the startup issues more shares at a lower price in the future. E.g. Full ratchet.
- It is a very important concept to understand while raising funds.
- It is the maximum price at which you will convert an investor’s contribution into equity.
- Example: Elon invests $2 million into “Firm Z” at a valuation cap of 10 million. In the priced round, Mark invested $2 million in “Firm Z” at a valuation of $20 million.
- Now the ownership of Elon and Mark will be calculated as follows.
- Elon and Mark both invested $2 million. But because of the valuation Cap, Elon has more ownership than Mark.
- Companies either provide a valuation cap or a direct discount.
- A loan that will be repaid with shares of the company instead of money.
- Interest rate and maturity date are typically included.
- The investors are provided with a valuation cap or discount.
- Example: Investor provides $100 as a convertible note, and with a 12% yearly interest rate, the founder will owe $112 worth of shares when the next financing round occurs.
CCPS (Compulsorily Convertible Preference Shares)
- These are preference shares that must convert to equity after a set period or achieving predefined milestones.
- These shareholders are provided with dividends that are paid out annually or accumulated to be paid at a later stage.
- CCPS converts either at a 1:1 ratio or a higher rate based on liquidation preference and participation.
- Investors have preference over equity shareholders in a liquidation event and may participate in surplus profits.
- Founders may prefer CCPS for a guaranteed conversion and potential control in liquidation events.
CCD (Compulsorily convertible debenture)
- Bond-like instruments that convert to preference or equity shares upon maturity depending on the terms set at the time of issuance.
- Employed as debt with regular interest payments initially, converts to shares on maturity of debenture.
- No specific minimum investment varies depending on the startup and investor agreement.
SAFEs (Simple Agreement for Future Equity)
- No interest rate or maturity date involved.
- Investor provides funding that converts to shares in the future funding round.
- Convertible notes offer more flexibility, allowing founders to set a specific conversion trigger, such as a total funding amount, before converting the investment into shares.
- SAFEs typically require immediate conversion during the next priced round.
Types of SAFEs:
- Example: 1 million at 9 million pre-money valuation would result in valuation of 10 million after funding.
- Investors have uncertainty about their ownership percentage in the company until the first priced round when all SAFEs convert to shares.
- Complex calculations required to account for multiple SAFEs and dilution.
- Pre-money SAFE has potential for less dilution in the long run.
- Example: 1 million at 9 million post-money valuation would result in valuation of 9 million even after funding.
- Investors lock in their ownership percentage at the time of investment, providing clarity and certainty about their stake when the Series A begins.
- Post-money SAFEs can lead to founder’s ownership percentage being diluted in the future, as fixed ownership percentages are established for each investor.
- Simplifies negotiations and transparency for both parties.
- Post-money SAFE gives more clarity and certainty for both founders and investors.
Startups with minimal revenue can use convertible instruments to raise capital without having to set a valuation. Convertible instruments allow startups to delay setting a valuation until a later date when they have more data and are in a stronger position to negotiate a fair valuation. This can be a major advantage for startups, as it gives them more time to grow and develop their business before they have to give up equity.
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