Early Stage Financing Models

In the early stage of a company, financing is key.

Seeking bank financing without early revenues and collateral misses the brief. Sooner or later, companies look to investors for funding.

Issuing common or preferred equity is one approach, the obvious issue being the negotiations around the company’s valuation. Do $250.000 buy 1%? 5%? 25%? A majority?

Investors will tend to ask for more shares, valuing the company lower. They will point to a lack of revenue, high risk, incomplete IP rights, and other weaknesses intrinsic to the early stage.

Founders will tend to resist giving more shares and losing control, meaning they will value the company higher and argue with future potenial, such as earnings and growth.

Seed and startup valuation can be speculative. Comparing competitors is difficult in innovation. Meaningful historical data is often missing; revenue, earnings, or cash flow multiples can become arbitrary quickly, their projection relying on too many assumptions. Finally, book values are not very helpful – the nature of the early stage goes beyond a static balance sheet.

The actual post-money percentage the investor will end up acquiring can thus become arbitrary, which means both sides will likely be wrong and may develop buyer’s remorse in retrospect.

For this reason and others, market participants have developed alternative early stage financing models, a few of which we summarize here. All postpone the timing of valuing the company to a later financing round.

  • With a Convertible Note, the note holder makes a loan that is converted into equity upon a “Qualified Financing” – a significant, higher investment. The logic is that at that point in time, the incoming investor’s valuation will be (more) reliable than projections today. The note holder is rewarded for his early and thus riskier investment by converting the outstanding note under more favorable terms (than the incoming investor) into equity. The challenges in negotiating a convertible note include finding an appropriate interest rate, even though the primary return for a note holder’s risk is the discount or cap on the company’s valuation upon conversion. Interest is then either paid periodically in cash or capitalized to principal and ultimately converted alongside principal. Finally, the note holder’s main interest is less behaving like a lender, rather participating in the equity upside.
  • The SAFE (Simple Agreement for Future Equity) builds on the convertible note. It is an agreement for future equity – the parties shed the umbrella of “lender-borrower” and instead document the real economics, an investment today in exchange for future equity on discounted terms. This also avoids issues surrounding the interest rate. The challenges in negotiating a SAFE include the lack of investor protections that customary debt documentation provides, including representations and warranties, covenants, and events of default, as well as its treament in insolvency.
  • The K.I.S.S. (Keep It Simple Security) builds on the SAFE, and comes both as debt (Debt-KISS) and equity (Equity-KISS). Among other things, it addresses criticism toward the lack of investor protection, and standard forms include representations and warranties, covenants including information rights, and events of default. The challenges in negotiating a KISS include having to deal with more issues, in some cases even more complex ones than with the original convertible notes.
  • Ratchet clauses allow investors to receive an interim percentage of equity today, while the final percentage and class is adjusted upon a Qualified Financing, when a valuation of the company is less speculative. The difference between the interim and final valuation is trued up in both directions with founders’ or investors’ shares, under conditions agreed to at the outset. The challenge of Ratchet clauses include the complexity associated with creating the class upfront and the extra steps in effecting the true up or conversion.

Since each structure, whether established or innovative, has pros and cons, the choice of structure should fit the situation. Investors can more precisely tailor their investment strategies and decisions, while companies can more effectively manage their capitalization with the right product.

Last but not least, all parties will be required to strictly comply with increasingly changing securities and capital market rules and regulations.

If you have any questions or would like to learn more, please free to contact Keyvan Rastegar with questions.

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