What Type of Money to Raise
A.T. Gimbel shares a high level guide to types of funding your business can raise.
equity, convertible note, SAFE, or revenue financing
Congratulations! You’ve made the decision to raise some money to accelerate the growth of your business and reach your desired outcome faster. There are now so many options out there: equity, convertible notes, SAFE, revenue-based financing, as well as several other variants. While there are many variables to consider such as stage of business, business model, market, etc. for this purpose I will focus on early stage entrepreneurs looking to raise their first formal round of capital. Note this is a high-level guide, as there are many nuances to each of these capital raising types.
Equity raises commonly occur in later rounds from traditional VC investors. Term sheets can range from simple to complex depending on valuation, ownership, control, and many other variables. The advantage is once negotiated, these terms are now set and clear going forward. Historically equity rounds took longer, had more nuances, and cost more to execute so early stage capital raises did not always go this route. Now there are simple series seed documents out there that can speed up the process and lower the cost of executing if the investor is amenable; I have even seen one page equity term sheets.
Convertible notes are often used with early investors as a way to move quickly and not deal with setting a current valuation. The key points are usually discount rate, valuation cap, interest rate, and maturity date. While these can appear easier to get started and can allow for rolling closes, there are challenges with punting the valuation discussion down the road. There are also risks for investors and founders around future dilution, qualified financings, ability to add future investors, and tax treatments.
Simple Agreement for Future Equity (SAFE)
SAFEs started out of Y Combinator as a simpler alternative to convertible notes and are often used with early angel investors. You mainly just determine a cap and/or discount, and the rest of the documentation is set. The advantages are simplicity, accounting and flexibility. There are some similar dilution and control risks as convertible notes, as well as other challenges due to a lack of maturity date.
A more recent trend, these are essentially a short-term loan for up to some % of your recurring revenue (i.e. 30%) paid back over some time period (i.e. 36 months) based on a % of monthly revenue (i.e. 5%) that typically has a payback cap (i.e. 2.0x amount borrowed). This option is not usually available until the business has achieved some level of annual recurring revenue (i.e. $500K ARR). These are usually more expensive than a bank-loan, due to effective high-interest rates and a short payback period. However, it is often non-dilutive which is a huge plus for entrepreneurs not wanting to give up equity and that have enough traction in their SaaS model to qualify for this type of financing.
For legal fees and support, it depends on how complex the business/cap table are and how many warts. But generally for $1-3K you can do a SAFE or convertible note, and for $3-15K you can do a seed equity round.
So what to do
In general, convertible notes often bring risk into the business for future financing that an equity round solves (for only slightly more cost and documentation). With convertible notes, in some cases the founder, angel investor, and/or future investor get into difficult arguments over valuation and ownership percentage being different than they thought or expected. This also becomes a much bigger concern when you start issuing notes on top of notes for future financing and/or can't trigger the "qualified financing" thresholds. With all the risks associated with building a business, why not eliminate a potential cap table risk by doing an equity round for just a little more money and everyone is clear on ownership going forward?
Remember, entrepreneurs have been successful with each of these funding models so there is not just one best way. Evaluate the alternatives and find the best fit for you and your business situation. There are plenty of risks in starting a business; no need to add additional financing/ownership risks as well.