Let’s face it, the startup world fetishizes fundraising. Pitches have become a form of entertainment. Tech press sensationalizes funding announcements.
But despite all the buzz, you should think long and hard about whether raising money is the right move. For many companies, it’s not.
Fundraising will eat a huge chunk of your time, lock you into a cycle where you must continue raising ever larger amounts of money to survive, and dilute your ownership and control as a founder. If you can build a profitable business any other way, do it.
But if you are truly setting out to build a high-growth startup tackling a multi-billion dollar market, then teaming up with the right investors is key. More than just providing capital, great investors contribute know-how, credibility and connections.
Before closing your first check, you’ll need a feel for the milestones that investors expect at each round of funding. You’ll need to understand the pros and cons of the various investment instruments and when to use them. And you’ll need a working vocabulary of the terms you’ll be negotiating.
So, here’s your cheat-sheet.
How much money should raise, and when? While the definitions are fluid, early-stage investing is usually framed in three buckets: Pre-Seed, Seed, and Series A. Here are finger-in-the-air approximations for each:
These are merely rough rules of thumb, and they’ve been changing significantly from year to year. To Jason Calacanis’s point, the definitions are less important than the headline goal for each round, which can be summarised as minimum-viable product (round 1), product-market fit (round 2), and sustainable growth (round 3).
Since this post is about closing your first investor, it’s worth highlighting that angels (much less VCs) don’t invest in business plans anymore (unless you’re Elon Musk). You need at least a prototype, and preferably a minimum viable product and some initial customer traction, before you spend time and energy trying to raise pre-seed funding.
With those funding milestones in mind, let’s survey the investment instruments at your disposal and consider when to use each one. (It goes without saying though that I’m not a lawyer and this isn’t legal advice — just my notes as a fellow founder.)
An equity round or “priced round” is when you and your investors agree on a valuation for your company and issue new shares to those investors. This often involves negotiating additional terms such as liquidation preferences, anti-dilution rights, boards seats, etc. It's the most complicated (and therefore most time consuming and expensive) method of the three, and for that reason is usually reserved for Series A rounds, and most certainly involves attorneys.
Here are a few very basic terms, though there are many others:
In short, equity rounds are usually reserved for Series A.
But they are getting easier and cheaper. Here’s a blog post from Yokum that compares several sets of standardized equity seed round documents.
The convertible note circumvents much of the complexity of equity rounds, though it introduces some complications of its own. The convertible note is a debt instrument that converts into equity at a later point, usually at a subsequent equity round. This makes it a good candidate for pre-seed and seed investments that are intended to convert into equity at Series A.
Rather than set an explicit valuation, the convertible note typically features both a valuation cap and a discount rate (though it can have just one or the other) which determine how many shares the investor receives when the note converts into equity.
However, since the convertible note is essentially a loan, it also includes a maturity date (when it has to be paid back) and interest rate. Therein lies the catch 22 of the convertible note: it can lead to a founder/investor conflict if the maturity date is reached before a conversion event has occurred, since the startup would at that time be obligated to repay the investor.
Here are the terms you need to know:
While equity rounds used to be the only way investments were done, the relative ease of the convertible note led to its widespread adoption for early-stage startup investments around 10 years ago. But you have to watch out that the maturity date doesn’t came back to bite you.
Wouldn’t it be great if there was an investment instrument that offered the simplicity of the convertible note without the maturity date risk and loan-that-isn’t-intended-as-a-loan awkwardness?
There is: it’s called a SAFE, or Simple Agreement For Future Equity. It features a cap and discount just like the convertible note, but it’s not a loan and it doesn’t have a maturity date or interest rate. There are only two terms to negotiate with your investor:
Since its creation in 2013 by YCombinator, the SAFE has quickly become the go-to instrument for early-stage fundraising in Silicon Valley, and increasingly across the U.S. (though it’s still a novelty outside the U.S.) I recommend using it unless you have a good reason not too.
For more about the SAFE, see: https://www.ycombinator.com/documents/
We briefly defined the cap and discount when talking about the convertible note and SAFE above, but they can take some effort to wrap your brain around. Here’s an example to better understand the interplay between the cap and discount.
Let’s say someone invests $1 million in your startup on a convertible note with a $5 million cap and a 20% discount. Here’s how it would play out in both an up- and down-round scenario.
Whichever investment instrument you choose for closing your first investor, it’s important to follow the rules, file the right forms, and keep your affairs in order. Here are three important things to keep in mind.
Now that you know what investors expect at the pre-seed, seed, and Series A level, and are familiar with the common investment instruments and their key terms, you’ll be able to hold your own when closing your first investor. In my experience, my early backers have been some of the most supportive people I’ve ever had the privelege of working with. I hope you’ll be able to say the same.
This is the second post in my Startup Cheat-Sheet series. Here are others: