New Adventures in Startup Financing

For all the groundbreaking companies they invest in, venture firms are not known for being particularly groundbreaking when it comes to financing. There are SAFEs or preferred equity rounds with a lead investor. Period. But we are seeing some changes. Innovation is actually coming to startup financing and we are so here for it.

I’m often asked how startup fundraising works and I find myself repeating the same answer, which I’m going to paraphrase here. Most early stage companies have three options for raising capital: SAFEs, convertible notes, and preferred equity rounds. SAFEs (Simple Agreements for Future Equity) are a type of convertible note created by accelerator Y Combinator. In essence, the investor gives you money in exchange for the right to purchase shares at a later date at a discounted price. Then there are standard convertible notes, where the investor loans you money, it accrues interest, and then the investor or the company has the right to convert what’s due into equity at a later date. Finally, preferred equity rounds involve selling stock with preferential rights at a specific price. These rounds are typically “led” by one investor who sets the terms under which everyone else in the round also invests, and who usually picks up some extra goodies, like a board seat, veto authority over certain company decisions, and the right to receive company financials.

This summary is useful (if not earth shattering) because it is accurate. The vast majority of deals we see fall into one of these three buckets. At the same time, we are increasingly seeing a bit of innovation around the edges. Whether driven by the companies or the VCs, new structures and terms have been appearing with greater regularity. Here is what we’re seeing.

Common Stock Rounds. When you think of a priced round or a Series A you probably think of a preferred equity round. Where the investors get “preferred” shares, which essentially give additional rights along with the option to convert to common stock at any time. All of these preferred rights are nice for investors but also create a logistical headache for the company, who has to manage the different shares classes and rights and has to paper these complex agreements. One alternative that some companies are considering is keeping everyone in the same share class as common stockholders. This doesn’t exclude offering bells and whistles to certain investors, but does streamline the process considerably and means everyone is treated as one group for determining majority approvals. Très egalitarian.

Lead(er)less Preferred Rounds. If you have tried to raise a priced round, the first thing you probably focused on was finding a “lead.” In the company’s dream scenario, a few VCs would submit term sheets, the company would select the term sheet and partnership that was most appealing, and that VC would be its “lead.” The lead would then conduct detailed due diligence, including reviewing and reaching a final agreement with the company on the documentation. From there, every other investor signs on to those documents negotiated by the lead. But is a lead required? Not necessarily. The company can serve as its own “lead”—it can set the terms of the round, draft the documents, and then offer those terms to investors. The upside for the company is that they don’t have to give away a Board seat, the downside is some investors may be hesitant to come into the round if they don’t have the lead’s diligence to rely on and the Company loses out on building a relationship with a lead investor that could also serve as a valuable advisor. 

Non-Template SAFE Rounds. The beauty and ugliness of SAFE notes is that they are template documents. It makes things simple. But more investors and companies are opening up to revised SAFEs. On the company side, they may want to adjust the SAFE so they can remain an LLC until the SAFEs convert. On the investor side, they may ask for an MFN (particularly when it comes to valuation cap and discount) or a (loose) commitment to maintaining QSBS status. We’re also seeing an uptick in SAFE note side letters.

Secondary Sales. For every startup that is out there with a massive valuation there is potentially a founder who is doing fundraising calls from the coffee table in her studio apartment. Valuation does not translate into cash in the pockets of founders. There is some sentiment out there that if you really believe in your company you won’t sell your shares until the company goes public or gets acquired. But that’s a sentiment for rich founders who have either already exited, had a windfall from another startup, or have rich parents. This expectation hits women and people of color, who get paid less and may have less generational wealth, particularly hard. For so many founders, an early and partial payout is financially meaningful (and sometimes necessary). As a result, some founders are throwing a portion of their personal stock holdings into the pool of stock that is available for incoming investors. Makes sense to me.

I’m not offering this as an exhaustive list. The point is to give you some ideas of what is possible but also to remind you that you should be thinking about . . . what is possible. Each company and investor is unique and you are not required to use the same terms that worked for companies and investors that preceded you. You are in this business because you have a way of thinking about things that is different from everyone else. That is your superpower, so use it.

--Jessie Gabriel