Many startup projects begin with small investments from founders and friends or family who believe in the founders’ plan, product, or idea. As startups further develop their business offering and concept, they often require additional funding from outside investors to finance their activities and growth.
But without a minimum viable product or track record, the value of a company is extraordinarily speculative. This creates a challenge in determining the percentage of a company’s ownership that an investment will purchase—a point on which the interests of the founders and investors can be adverse. In such circumstances, investors are very likely to place a much lower value on the company than the founders. The lower the company’s valuation, the greater the percentage of ownership purchased by an investment and the more the founders’ stake is diluted.
For companies in need of capital at early stages, the risk of selling too much equity at too low a price is problematic. The founders’ stake should remain large enough after outside investment to ensure they continue with sufficient incentivizes to run the company. Additionally, the company should maintain a “clean” enough cap table to create room for future investments. However, as implied above, early investors will often push back on speculative valuations and, generally, will want to purchase equity at the lowest possible price.
Convertible notes and SAFEs are legal instruments that were designed to bridge this “valuation gap” between founders and early investors. These instruments bring the sides into closer alignment by postponing a determination of the company’s valuation until the company has advanced in its development to a stage at which the company and venture capitalists can agree on a mutually acceptable price per share in a “priced” investment round. This may occur once a company has developed a minimum viable product or after it has taken its product or service to market and developed data on traction metrics like revenue, cash flow, customer acquisition costs, user engagement, market share, and growth rates. In any case, the investors will have determined that the investment has become less speculative and that, at the agreed valuation, the opportunity merits taking on the high-risk implicit in all early-stage companies.
Convertibles notes and SAFEs use the valuation established in a “qualifying transaction” as a reference for determining the price per share at which the investment converts into equity in the company. Typically, these instruments determine the conversion price based on a fixed percentage “discount” on the price per share paid by investors in a future “qualifying” priced round. Convertible instruments may also establish a valuation cap, which sets a maximum price per share applicable to the conversion.
As reflected above, convertibles notes and SAFEs are useful tools for bridging valuation gaps because they balance the legitimate concerns of both investors and founders. By offering early-stage investors a discount on the price per share paid by later investors, they diminish the risk that early-stage investors overpay for their shares and reward them for taking on additional risk. By postponing the company’s investment valuation until the company has reached a stage in which a higher valuation can be supported, founders diminish the risk of valuing investments at too low a price and, in so doing, excessively diluting their equity. Ultimately, each side has a mutual interest in ensuring that the founder group remains incentivized to continue developing the company until it provides both with a positive financial return.
