One common refrain from founders that I talk to is “holy shit I didn’t realize it would be this hard to raise money”. There seems to be a common misconception even among people in the technology world that if they have a good idea and have worked at brand name companies, they should be able to attract institutional dollars. While that can certainly happen, this post is targeted to the majority of people who have come to the harsh realization that they will need to find a different way to fill the void between their idea on a napkin and institutional money. Usually this is done with investment from friends and family, angels or accelerators (in addition to your own savings).
I have received a lot of questions from founders at this stage regarding what investment vehicle they should use and how they should determine a valuation (or cap). This is not intended to be a one size fits all analysis and I am not a lawyer, so these are just my observations about common trends and dilemmas people face.
The sections below cover Convertible Notes and SAFEs. Before going into the details of what they are and why there has been an evolution from Convertibles Notes to SAFEs, it is worth pointing out that both of these investment vehicles are preferable at early stages of a company because of the reduced amount of paperwork they require, lower legal fees, avoidance of valuation questions and the ability to grant low priced stock to early employees.
What is a Convertible Note?
At a very early stage of a company, determining a fair valuation can be a very subjective task given all of the uncertainty and unanswered questions (as I imagine you have discovered). There is definitely an analysis that can be done on the market, team and proposed business model which can impact valuation (and whether it merits any investment at all). However, it tends to come down to trying to balance the incentives of all parties involved more than a rigorous financial analysis (ie maintain enough upside for founders, mitigate downside risk for investors and provide those same investors with significant upside).
In the past, this was commonly accomplished using convertible notes which are effectively loans (usually with an interest rate and term) with an option to convert the loan to equity at or below a given valuation cap. This is a mostly good vehicle for balancing the incentives of founders and investors. The exception being that given the relatively binary nature of expected outcomes, the interest rate and loan term, don’t really make a ton of sense. An investor trying to call their loan from an insolvent company generally won’t get anything back and in the event that a company is growing, if an investor did try to call their loan (rather than convert to equity) a company still may not have the cash available to repay it which could be disruptive and negatively impact everyone.
What is a SAFE and Why Should I Use One?
So instead of this gentlemen’s agreement between founder and investor when it comes to calling a convertible loan note, Y Combinator popularized a very similar investment vehicle called a SAFE (Simple Agreement For Equity). The primary difference between a SAFE and a convertible note is the lack of an interest rate and no maturity date. A SAFE typically still has a valuation cap (and often a discount which a convertible note can have too). This structure provides a more clear alignment of incentives between founder and investor and eliminates the possibility of a loan being called (I am reticent to say a “better” alignment, it just makes it more clear what the investor signed up for).
Any professional investor you talk to will likely have an understanding of how a SAFE works, but a lot of “friends and family” type investors will likely read the document and become really confused (along with founders themselves). Here is a quick explanation in a nutshell. A SAFE has two main levers- a valuation cap and a discount (but it is not required to have either). The valuation cap basically says “hey neither of us (founder or investor) really know what this company is worth, but we agree it’s not worth more than $X and we are going to punt on this question until the next liquidity event.” The discount says “hey investor, I am aware of how risky your investment is right now and that there are a bunch of different possible subsequent outcomes, so even if the next liquidity event is below the valuation cap, I want to make sure your investment converts to equity in a more favorable way than it would if this were a straight equity agreement”.
Taken together a valuation cap and discount allow the investor to have uncapped upside if the company is a rocket ship (because of the valuation cap) and potentially get an OK return if the company hits a “single” (because of the discount rate). For the founder, it eliminates the issues a convertible note poses with a term and interest rate and for both it eliminates the challenge of agreeing to a specific valuation and the associated risk profile . In the case, the company loses all the money invested, well then everyone is fucked…so it doesn’t really solve for that.
As a rule of thumb, the more leverage the founder has, the more likely to have no cap or discount and the more leverage the investor has, the more likely to have a lower cap and greater discount.
One last thing to note. Make sure you understand these mechanics before you start issuing SAFEs so you understand how much you will be diluted in the future. Here is a good article about that issue (with a misleading title).
What valuation cap should I use for my SAFE?
Hahaha. Great question. I wish I knew. Generally speaking, from founders I have spoken to they tend to be in the neighborhood of $2MM-8MM (with discounts all over the place). Even though there aren’t really great methods for determining these numbers, you should still be prepared to defend whatever you decide. The most common methods I have seen are:
- Accept what is market in your area (and this is mostly dictated by investors but often isn’t so bad since they want to ensure founders still have incentives).
- Use an expected value approach; to do this you would probably make a financial model going a few years out and then assign odds of reaching various performance levels in your model. Do research and make assumptions on how companies in your space are valued (ie what business metric drives their value) and then calculate a valuation for your company at each performance level in your model. Multiply each valuation by your estimated odds of reaching that level. Sum the results and you have an expected value approximation that is at least somewhat rooted in logic (hopefully).
- Start out at $6–8MM and then adjust based on how aggressively you are rejected.
The Friends & Family vs Professional Paradox
At this stage of your company, it will probably be easiest for you to raise money from friends and family. They likely won’t care as much about the cap (from what I have seen) and as a result you can probably get them to sign a document at the higher end of this range without thinking twice. The problem comes if you are then talking to a professional investor and they crank you down to a much lower cap number. Do you feel morally OK accepting their money at a lower valuation (ie more favorable terms for them) than your friends and family at a similar stage? Its just a common situation I have seen…so something to keep in mind as you ask people for money.