Convertible debt and SAFEs are among the most commonly used vehicles for early-stage companies to structure seed investments.
There comes a time in the development of a startup where it may decide to seek outside funding. During the earlier stages of the startup lifecycle, companies often look for a fast, painless way to bring in a modest amount of cash to support immediate needs as “seed” financing. While a few startups will prefer to raise seed financing by selling equity under a simplified equity structure, it is more common to see startups opt to raise seed money using convertible structures such as convertible debt or a SAFE (Simple Agreement for Future Equity).
What are convertible instruments?
Convertible notes and SAFEs are structures in which investors put money in now that is converted into equity later, upon the occurrence of a priced equity round. Convertible instruments contain several important terms to consider including the conversion discount, price cap, interest rate, and the non-economic rights of the investors. There are also some significant differences between notes and SAFEs, for example, concerning the term of the instrument, the “qualified equity financing” threshold, and economic rights if there is a sale before an equity conversion.
What are the advantages of convertible instruments?
There are three primary reasons that startups use convertible structures:
- The documentation is light and therefore quick and relatively inexpensive to complete compared to equity financings.
- These structures do not require the company to determine a valuation, which is speculative in the early stages of the startup lifecycle.
- Convertible instruments can also be used to raise “bridge financing” – an immediate, short-term infusion of cash that provides interim working capital while the company pursues an equity round.
What are the drawbacks of convertible instruments?
Some commentators contest the merits and advantages of convertible structures, pointing out that they can lead to excessive dilution of the founders and other problems. Nonetheless, it is indisputable that convertible notes and SAFEs have remained the most common structures for seed financing.
How does goodcounsel help with convertible financing rounds?
goodcounsel regularly advises its clients on convertible investment rounds. We will help you understand the important issues and make the right decisions.
A typical convertible financing matter includes:
- Developing the terms of the convertible note or SAFE with the client.
- Creating a non-binding term sheet for the client to share with prospective investors.
- Drafting the legal documents and making final adjustments.
For all financing transactions, we include federal and state securities law compliance. Some law firms will omit this work for smaller transactions; however, even a low risk of personal liability on the part of company founders, which can result from ignoring securities law issues, is too much when compared to the low cost of compliance.
goodcounsel’s scope of work also includes oversight and administration of the document execution process, which is managed by our paralegals using e-signature platforms.
How much will this cost?
As a law firm that focuses on startups and early-stage companies, we understand the importance of predictability and value. We are pleased to provide our clients with fixed-fee proposals for convertible financing rounds.
How long will this take?
Normal turnaround time once work commences is under two weeks. An accurate estimate of timing depends on a variety of factors, particularly the degree of investor negotiations.
Where can I learn more about convertible notes, seed equity, and related topics?
goodcounsel’s goodthinking! blog contains a variety of information relevant to early-stage companies, including posts about the relative merits of convertible notes and equity, the origins of SAFE financing, and more.
Can I just do this myself?
Maybe you could, but you shouldn’t. Smart entrepreneurs know where to focus and appreciate when it is better to rely on others to get a job done. This is one of those “rely on others” situations. An experienced startup lawyer will ensure that you consider, and your documents address, all the key terms as well as the less apparent nuances, and handle important related matters such as securities law compliance. Working with a qualified lawyer also demonstrates maturity and seriousness to your investors, and will enable you to keep a comfortable distance from the negotiation of the deal terms.