Unlocking growth: Key considerations for startup capital fundraising

As startups and other companies seek to grow, securing additional funding becomes essential. While additional capital and new investors can open doors to exciting opportunities, there is no single optimal way to raise capital. Instead, companies can choose from a range of fundraising tools, each with its own benefits and limitations. This blog provides a brief overview of common fundraising options available to help companies attract new investors and raise additional capital.

Equity financings

• In equity financing rounds, investors purchase equity in the company and become owners of a portion of the company. As a result, the new investment will dilute and reduce the ownership percentages of each of the company’s founders.
• While early-stage rounds may involve sales of common equity with similar rights as equity held by the founders, most equity financing rounds involve sales of convertible preferred equity, which have additional preferences and privileges over the common equity held by founders.
• A primary feature of preferred equity is a liquidation preference, which gives investors the right to be paid before holders of common equity and other junior equity in the event of a liquidation. The most common arrangement is a 1x liquidation preference, meaning investors get back the amount they invested. Sometimes, investors negotiate for a higher preference—such as 2x or 3x—allowing them to receive two or three times their original investment before any payments go to common equity or junior equity holders.
• Key investors often negotiate additional rights and protections to monitor and protect their investments, including (i) board representation or observer rights, (ii) veto or approval rights over certain company matters, (iii) preemptive rights in connection with future equity issuances, (iv) anti-dilution repricing rights if subsequent equity rounds are at lower valuations, and (v) rights to receive the company’s financial statements.
• Because investors will become owners in the company and negotiate protective rights and preferences, equity financing rounds are typically the most complex and can involve extensive documentation negotiation and investor due diligence.

Convertible debt financings

• Convertible debt financings involve the issuance of promissory notes that will convert into equity in the company, usually preferred equity, when a subsequent equity financing round occurs.
• Convertible debt holders have a higher priority than equity holders, including those with preferred equity, in the event of a liquidation. This means that if the company is liquidated, convertible debt holders are paid before any equity holders receive proceeds. As a result, convertible debt can offer greater protection to investors in downside scenarios.
• Convertible notes often have a maturity date 18-24 months following the initial issuance and accrue interest at rates between 4% and 8%. Instead of being paid in cash, the accrued interest is usually added to the principal and converts into equity at the next financing round.
• When a subsequent equity financing round occurs, the principal and interest outstanding under a convertible note will convert into equity at price determined by a discount rate or a valuation cap. While some convertible debt includes both a discount rate and valuation cap, convertible debt often includes only one of these pricing mechanisms.
  • A discount rate reduces the price at which the convertible note converts compared to the price paid by new cash investors in the next equity round. For example, if a cash investor pays $100 per share in the next equity financing round, a convertible note with a 20% discount rate will convert at $80 per share. Discount rates typically range from 15-25%.
  • A valuation cap sets the highest pre- or post-money valuation at which the convertible note will convert into equity. For example, if a convertible note has a pre-money valuation cap of $5 million, it will convert at a $5 million valuation if the pre-money valuation in the equity round exceeds $5 million, regardless of how much higher the pre-money valuation is. On the other hand, if the pre-money valuation in the equity round is less than the $5 million valuation cap, then the convertible note will convert at the actual pre-money valuation.
• Convertible debt rounds are usually simpler than equity financing rounds, with fewer documents, less diligence, and fewer investor rights and protections. However, depending on the size or structure of the debt financing round, investors may require more thorough diligence and protections similar to those found in equity rounds.

SAFEs

• A simple agreement for future equity (SAFE) is a fundraising tool that is neither debt nor equity. Instead, with a SAFE, the investor receives a right to receive something from the company in the future, most likely preferred equity through conversion of the SAFE when the next equity financing round occurs. However, a SAFE may never convert into equity; instead, the investor could receive a cash payment if a liquidation, change of control, or similar event occurs.
• SAFEs are open-ended without a maturity date and do not accrue interest.
• Similar to convertible debt, the investment amount of the SAFE will convert into equity at price determined by a discount rate (usually 15%-25%) or a valuation cap (usually a post-money valuation cap).
• SAFE rounds are simpler than convertible debt or equity rounds and usually use a standard agreement with little negotiation, except for the discount rate or valuation cap. Investors generally do minimal due diligence in a SAFE round. While investors may request additional protections or preferences, these are usually limited to most favored nation terms, which ensure the investor gets the best terms offered to any other investor, or preemptive rights to invest more in the next equity round.

McDonald Hopkins' M&A attorney Francis Massaro is available to answer questions regarding equity, debt, and other capital fundraising issues.