If you’re starting your first company, understanding stock, preferred stock, options, convertible notes, angel investing, venture capital, and other fundraising instruments can be truly overwhelming. We didn’t find a single video that covered this, so here we go.
If you are an early-stage startup company in the tech space, the best way to raise capital is with a convertible note or a similar instrument. However, to understand how those work, we first need to understand how stock works.
You are probably familiar with the term ‘stock.’ A company is divided into chunks, and each shareholder owns a certain percentage of the company, which gives control of company decisions, and a share of the profits.
A PRICED ROUND: RAISING MONEY FOR STOCK
The ‘traditional’ approach towards raising capital is with a priced round. Tech companies are different. Tech companies have tremendous scale potential and often fantastic margins. A software product or an app, for example, can realistically operate with 80%+ margins, and serve millions of customers around the world, with a minimal staff. Think of Uber, who raised $500,000 on their first round, and are now worth, well, billions of dollars.
So the value of a startup is not related directly to their revenue, but to their potential. Some variables to take into account here are:
– The market size, how many customers are there in the world.
– The technology variable, is there a unique piece of tech that nobody else has, or that optimizes a process drastically?
– Potential margins, how many employees are needed to serve 100,000 customers or 1,000,000 customers? When Instagram had 300 million users, their staff was 13 people.
However, all these numbers are variables and theories, and nobody knows for sure. The valuation of a startup is defined by how much potential an investor sees in the business, how risky it is, and how much upside do they want in exchange for risking their money, just like a bet.
These days, a reasonable number for a tech company like our theoretical FounderHub would be a $4,000,000 (pre-money) valuation. Again, assuming this is a high scale, high margin business.
All of these decisions require negotiations, and lawyers, and signatures to be put in writing, and they can make the process take six months or more from ‘agreeing to invest.’ Since most early companies don’t have six months, they often choose to go with a Convertible Note.
A convertible note is an instrument that delays the valuation conversation, and it allows the company to access the capital sooner, with less negotiation and much smaller legal fees.
A convertible note is like a loan, but instead of using an asset like a house for collateral, the company stock is the collateral. This means, obviously, that the investor also needs to believe in the business to invest, because the note intends to convert into stock.
Like I said before, defining a company valuation is tough. Too many variables, too little data… so with a convertible note, the investor is saying: I’ll give you the money for you to grow now. In a year or so we should have the data to support a priced, traditional round, so my investment will convert then, with the valuation and terms that the new investors define.
So a convertible note is an investment that triggers,
– Ideally, on a new round of funding.
– Also ideally, if the company is acquired.
– At a predefined deadline, often 18 or 24 months after the original investment. At this point, investors can negotiate a note extension, they can convert it at the Cap, or they can request a payback, again, if the company can afford it.
Now, YCombinator and 500 Startups have both designed documents inspired by convertible notes, but simpler. And free.
The KISS-A (Keep it simple security) and the SAFE (simple agreement for future equity) are simplified convertible note templates that you can use to raise money and skip lawyer fees. You can download it on our FounderHub site, and refer to our knowledge base for more details on completing it.
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