WRITTEN BY DANIEL RIZZI, STARTUP LAWYER AT DIMINNO RIZZI IN ASSOCIATION
Founders come in all shapes and sizes, but rarely do they have a complete understanding of all the possible options they have when raising capital. As a Tech Startup Lawyer, I help startups raise capital all the time. The majority of founders are simply presented with a term sheet by investors and don’t know which terms they can push back on, including how the round is structured.
Many founders think the SAFE agreement is the best founder-friendly solution when thinking about fundraising, but there are some important trade-offs that SAFEs make. Even experienced founders potentially leave money on the table when better options were available. Experienced investors generally have far more deals under their belt than a founder, and they use this knowledge gap to their full benefit.
Getting Ready for the Capital Raising
There’s a lot to do to prepare for a fundraise. If you’ve been organized, creating a data room will be an easy process. A data room is generally a cloud folder (with subfolders) with all the documents relating to your startup, including contracts, incorporation documents, cap tables, financial statements, customer quotes, and potentially other types of documents depending on the size of your company. There are also specialized platforms that let you track who has viewed the data room and what they’ve done inside.
If you haven’t already, you’ll need to incorporate your business. Investors rarely invest in a non-incorporated business. You should make sure you’ve been filing your taxes (even if the business hasn’t had revenue) and you have up-to-date financial statements. Not having these administrative steps taken makes founders look unprepared and disorganized.
You’re also going to need to figure out how much money you need to raise. This might look like a business plan for an early-stage business, or this might be complex financial modelling looking at ad spend, marketing, revenue projections, and headcount for more advanced businesses. Investors want to know what you’re doing with their money and how you’re going to grow the business.
You’ll also need to put together a pitch deck. A startup pitch deck summarizes for investors the opportunity your company presents. Tech companies follow a pretty standard formula for what investors are looking for, and deviating from this can be a negative in the eyes of investors. You’ll also want to be able to track who views your deck and what they focus on; DeckLinks is a great tool for this.
Typical Routes of Capital Raising
Looking for funding for your startup is like working on a challenging puzzle, where every piece represents a different source of funding. But don’t worry, we’ve got you covered! Knowing your startup’s needs, stage, and industry can help you figure out which funding sources will fit at which times.
Friends and family
Starting a company can be daunting, but friends and family can be the key to launching your dream. They’re often the first ones to provide the seed money you need to get your business off the ground. Their investment is all about their belief in you, not just your product. It’s like a warm hug and encouraging push that sets you on the path to entrepreneurial success.
Angel investors are typically high-net-worth individuals who provide capital for a startup in exchange for convertible debt or ownership equity. They are the silent heroes or ‘angels’ who swoop in after the friends and family round, helping your startup take flight.
Public or private business incubators
As a startup, your success depends on finding the right environment to thrive. Think of business incubators like tailor-made greenhouses for your business to grow. With both public and private options available, you’ll get the funding you need plus access to invaluable resources like office space, mentorship, and key networking opportunities.
When your startup is ready to take the next big step toward growth, the seed investors are the ones who can help you out. By offering funding in exchange for a share in your company, they can help you expand your operations, explore new markets, or enhance your product offerings.
Venture Capital (VC) funds are typically the big players in the startup financing world. They’re like the heavy machinery that comes in when your startup is ready to build skyscrapers, not just houses. VC funds usually invest large sums in promising startups in exchange for equity, often playing a more active role in guiding the company’s direction.
How to Raise Capital for Your Startup
Startup companies raise capital because it accelerates the growth of the business, brings the founders some short-term financial stability, and is seen as a mark of success to be externally validated by investors by raising a significant sum of money.
As a tech founder, you probably want to build your business instead of worrying about the paperwork for a fundraising round.
It’s important to understand the pros and cons of how you structure a round. If you assume your business will be successful and be worth $100 million+ in the future, you need to take these decisions seriously. Even small decisions could cost you millions later. Learning how to fundraise as a tech startup is required on your journey to becoming a successful founder.
Types of Capital Raising for Startups
Tech Startups in the US and Canada fundraise generally through three methods; A SAFE Round, A Convertible Note (or Convertible Debenture) Round, and a Priced Round. Each has its own pros and cons, and there are some details the common understanding of these agreements has left out.
Raising Capital for a Startup via SAFE Notes
A SAFE stands for Simple Agreement for Future Equity. It was created by the US tech accelerator Y-Combinator, considered the best accelerator in the world, and lists some of the biggest tech companies as part of its portfolio, including AirBnB, Stripe, Coinbase and Brex.
Y-Combinator saw that its founders were spending a lot of money on lawyers and the early fundraising rounds were taking too long. Y-Combinator companies see almost an extreme interest from investors and these companies want to move as fast as possible.
Here is the link to Safe Financing Documents by Y-Combinator.
How do SAFE notes work in raising capital for startups
The way SAFE notes work is deceptively simple. An investor gives the company capital. The Company promises the investor to give them shares at a later date once they do a more formal fundraising round. The terms of these shares will be negotiated by the lead investor of this larger round and will have significant investor protections. The investor will also receive a discount on those shares as a reward for investing early and taking on more risk than the later-stage investors. A SAFE note also defers giving the company a “true” valuation until later, but see valuation caps below.
Now, while you should have a lawyer review a SAFE agreement to see if anything was slipped in, in theory, if the SAFE note is the same as the standard template agreements it should be low risk to fill in the numbers and sign it (this is not legal advice).
The main terms of a SAFE note that you need to look out for are the discount rate and/or the valuation cap. Very simply, if the discount rate is 80% (meaning you pay 80% of the price), the investor’s money buys them 20%~ more shares than that same amount of money would if they invested at that later round. A valuation cap is another incentive mechanism. If, at the round, the SAFE note converts into shares, the Company’s valuation is set at a higher amount than the valuation cap, and the investors get more shares.
For example, if your valuation cap is $2 mill, and at the round, the SAFE note converts at the company raise at a $4 million valuation, the investor gets approximately double the amount of shares their money would normally buy.
What are the pros of SAFE notes in raising capital for a startup?
The Pros of a SAFE note are that there is a low legal cost to getting it reviewed by a lawyer, and you could take the risk and run the whole round by yourself. There’s also no interest paid on the funds the investor invests. SAFE rounds are generally faster than other types of fundraises and they come with the least investor protections.
What are the cons of SAFE notes in raising capital for a startup?
The Cons of a SAFE note are the founders will likely get diluted more than with a priced round. If the founders end up doing multiple rounds with SAFE notes their dilution will likely be more than they intended. It’s also expected that you will fundraise again quickly, so this isn’t ideal for businesses with slow growth. SAFE notes are also complicated cap table calculations making it harder for founders to track their dilution.
What’s the difference between US SAFE notes and Canadian SAFE notes?
In Canada, NACO has developed a “Canadian SAFE” template. Ideally, this should be used over the Y-Combinator SAFE template, although the NACO Canadian SAFE is a longer agreement with more investor rights. I’ll note that Y-Combinator has a Canadian Safe template on its website, but this is for US companies raising capital from Canadian investors, and not Canadian Companies raising from US investors as one might mistakenly assume. Some Canadian big firms have converted the Y-Combinator SAFE to a more Canadian agreement, you may come across this as well.
Raising Capital for a Startup via Convertible Notes
A Convertible Note basically removes the pros of a SAFE note and brings with it all the cons.
How do Convertible Notes work in raising capital for startups
Convertible Notes work the following way. An investor gives the company money. The Company promises to pay the money back to the investor (held as debt). Interest is due on the debt, but payments are not due until the note converts into shares, or a period of time passes where there is no conversion.
In a way similar to a SAFE note, the Convertible Note converts into shares at a larger fundraising round, normally a Series A round. Investors will likely get a discount on their shares on conversion in a way similar to a SAFE note described earlier.
On conversion, the interest on the debt will also convert into shares. If there is no conversion event, the Investor will generally have various remedies available, including demanding payment or continuing to wait for a conversion event.
Convertible Notes will generally come with significant investor protections, including securing the debt against the assets of the company. This means if the company goes bankrupt, the investor will likely receive all the money from the sale of the assets of the company, up until they are fully paid back with interest.
A convertible note will take less time to close than a priced round, but you absolutely need lawyers involved, and this should be considered a fully-fledged transaction with significant legal costs included. If dealing with sophisticated investors there will likely be an extensive due diligence process, both on the legal and the business side.
What are the pros of Convertible Notes in raising capital for a startup?
The Pros of a Convertible Note are that investors are more protected, so it makes it easier to raise using one. Investors not familiar with the Tech industry will have an easier time understanding the debt component.
What are the cons of Convertible Notes in raising capital for a startup?
The Cons of a Convertible Note include all the cons of a SAFE note. Convertible Notes are slightly cheaper than a priced round but are comparable in cost.
Raising Capital for a Startup via Priced Rounds
A Priced Round is the most traditional way of giving equity in exchange for financing.
How do Priced Rounds work in raising capital for startups
An investor buys shares from a company at an agreed-upon valuation. The investor is now a part owner of the company, and the company now has funds to scale the business with.
Priced Rounds are typically done for Series A rounds and beyond. Investors will generally receive preferred shares in these rounds in exchange for their investment. Preferred shares will generally give investors priority over common shareholders in the event of an exit event, along with other investor protections.
A priced round can be done at any time before a Series A, however, the founders can determine what type of shares the investors purchase. The simplest shares are common shares. Common shares give investors the ability to vote in shareholder meetings, an entitlement to dividends, and part of the money generated from the sale if the company gets sold.
With the help of a lawyer, founders can create different share classes that alter these rights. One common way is to remove the voting rights, creating non-voting common shares.
What are the pros of a Priced Round in raising capital for a startup?
The Pros of a Priced Round are that founders can dictate what types of shares investors get (before a Series A) giving founders more control over the deal early investors are getting. Founders can calculate exactly how much they’ll be diluted by the round, and investors are not getting a discount like with a SAFE note or Convertible Note, so in the long term, founders are diluted less.
What are the cons of a Priced Round in raising capital for a startup?
The Cons of a Priced Round is that a valuation is set. A Priced Round is also the most expensive option here, with potentially the most due diligence done by the investors. Assuming your company is successful, however, the increased costs may be greatly outweighed by the value of the equity retained by the founders.
When to Choose SAFEs, Convertible Notes, or Priced Rounds for Raising Capital?
Picture yourself embarking on a thrilling journey to the future of your startup. You find yourself at a crucial moment, where three paths diverge before you. Each path represents a different way of raising capital and takes you through the tangled woods of startup financing. On your left, there’s the easy-to-follow SAFE trail; straight ahead, you’ll find the Convertible Notes path, while on the right, you’ll see the more challenging Priced Rounds road. The big question you face isn’t just which path to follow but rather when to start the journey down each one.
When to choose SAFE Notes to raise capital?
Think of SAFE notes as a rapid, gurgling stream. You’ll love them if you’re running a startup in the early stages, like a quick dip in a stream on a hot day. SAFEs are uncomplicated, quick, and inexpensive, kind of like testing the water by dipping in your toes. They can be the ultimate solution for swiftly raising capital without setting a specific valuation for your startup. It’s perfect for raising funds when launching your startup. Speed is the name of the game here.
When to choose Convertible Notes to raise capital?
Convertible Notes are a river that keeps flowing steadily. Startups that have an MVP or early traction but aren’t quite ready for a valuation just yet can raise capital using Convertible Notes. Think of Convertible Notes as a structured way to raise capital – with an interest rate and maturity date built right in.
When to choose a Priced Round to raise capital?
Think of Priced Rounds as the ultimate plunge into the startup fundraising ocean. They’re perfect for established startups with a strong value proposition and product market fit. Investors are eager to hop in and back your venture with serious cash.
Should I Raise Capital as a Tech Startup Founder?
Let’s face it, raising capital as a Tech Startup Founder seems glamorous. Tech publications write articles about you. Friends and family will be amazed by such a large chunk of money going to you. Your company has been validated by people with a lot of money, and that must mean something right?
Just because everyone else is doing something, doesn’t mean we should do it. In fact, we only hear about success stories in the media, but never about the thousands of failures that happen regularly. Even if a company does successfully exit, what they don’t tell you is how much the founders take home from the deal. There are cases of companies selling for tens of millions of dollars and the founders end up with $0.
Importance of Legal Advice When Raising Capital for Your Startup
Picture steering a ship through a stormy sea with no compass – that’s like navigating the fundraising world for your startup without legal advice. It’s a risky journey, full of potential hazards and pitfalls. With so many critical fundraising tools like SAFEs, Convertible Notes, and Priced Rounds, it’s essential to enlist the help of skilled legal counsel to help you steer clear of trouble.
A startup lawyer will help you navigate the legal labyrinth
It’s important to have a legal expert by your side who can help you navigate the maze of legal issues that come along with it. From deciphering investor agreements to complying with government regulations, and from intellectual property rights to employment laws, there are many complexities to consider. A single mistake can result in unwanted legal battles, fines, or worse, the end of your startup dream.
A startup lawyer will protect your startup’s interests
An experienced startup lawyer doesn’t just help you avoid pitfalls, they’re also instrumental in ensuring your startup’s interests are protected. Picture your lawyer as the gatekeeper of your startup castle, safeguarding your interests against potential threats.
A startup lawyer will help you negotiate and structure fundraising deals
Finally, when it comes to negotiating and structuring deals, having legal advice is akin to having an ace up your sleeve. Lawyers can ensure that funding agreements are structured in a way that optimizes financial outcomes and minimizes risk.
Legal advice is a crucial part of startup fundraising – it’s like the steady beat that keeps everything in tune, providing a solid foundation for your startup success story. Before you hit the high seas of fundraising, be sure to have a seasoned legal guide to steer you in the right direction.
Making the Best Decision in Raising Capital for Your Startup
In summary, fundraising makes a lot of sense for certain types of companies at the certain stage. For the majority of companies, they may actually be getting a bad deal.
This basic guide serves as the foundation for raising capital and covers the overall basics of fundraising for a Tech Startup. Different types of rounds come with their pros and cons, and the structure of the round would depend on your end goal. If you need any help thinking about these things please reach out!
About the author
Daniel Rizzi is a Toronto based business lawyer that helps founders in software, Crypto, Fintech, BioTech, and the AI space navigate the legal landscape and make better decisions. From incorporations, shareholder agreements, terms and conditions, privacy policies, to fundraising and M&A, Daniel helps the underdogs become titans.