Deal Structure
Preferences and Best Practices
(This is part seven of a 9-part series on raising Seed capital in PropTech. For the rest of the series, check here.)
I’ll keep this simple — Priced equity round are always best.
The end.
Do I need to write anything else?
Fine.
I know that there is a tendency toward simplicity and speed in Seed Stage fundraising. So finding a commonly-accepted document to fundraise with seems like an easy answer right?
Wrong.
SAFEs
SAFEs (Simple Agreement for Future Equity) is an instrument created by Y Combinator years ago that served as a simple, relatively clean fundraising structure for early stage startups and Angel investors.
You could substitute the word “Angel” here with the words “inexperienced and not-highly-structured”. SAFEs are meant to be simple, not comprehensive. Those of us who have limited partner agreements and great attorneys need comprehensive.
So, rather than speeding up and simplifying fundraising for a startup, SAFEs actually slow down the process because we always have to negotiate and tweak them. What you eventually end up with is this highly-altered FrankenSAFE that looks very different than the one you can download from the YC website.
And I know I’m not the only one who thinks they are . . . suboptimal. Pascal Levensohn, Daniel DeWolf, John Rampton, The SEC, Nikhil Kapur, and Fred freakin Wilson agree with me. Fred alone is enough.
Don’t use SAFEs. They served a purpose in the past. Now they cause more problems than they solve.
(Since that’s my advice, I’m not going to cover discounts, valuation caps, or anything else common in SAFEs. Just Google it if you want to know and send your deck to one of my competitors.#Sabotage)
CONVERTIBLE DEBT
Convertible Debt is another highly-popular but still ineffective structure.
I’m not sure why, but convertible debt (aka convertible notes) seems to appear safer to angel investors.
Maybe it’s because CNs are called “debt” and a finance textbook would tell you debt is safer than equity because of capital-stack seniority. (Congrats, Mr. Plaintiff! You have the most senior claim on a company worth $0!!!!)
Maybe it’s because there’s an associated interest rate paid on the investment and so the appearance of cash-flow makes investors feel safer. (You know that’s coming from future capital raised, not positive cash flow, right?)
Maybe it’s the discount when the debt converts to equity and investors always want discounts. (What’s 20% off shares in a company worth $0?)
Whatever the reason, it’s all nonsense. The startup, and its associated risks, are exactly the same no matter whether you hold a debt or equity interest. It’s the same team with the same challenges. Calling it debt that converts to equity doesn’t help at all.
Conversion can be messy. Messy = Slow. Is that what you want?
No, you should do priced equity rounds as soon as you raise money. It will make your life simpler, I promise.
PRICED EQUITY
What does that mean?
Priced Equity simply means you are putting a price on the company. How much is it worth today? And you are accepting capital as equity and not as debt. (Priced Debt is another thing = Venture Debt, but that’s a topic for later.)
How do you price equity?
Well, you are going to determine how much capital you need to raise and then back into a valuation for your company.
If you need $2M and we have already established that you should probably benchmark giving up 25% of you company in your Seed round, that means you are looking at a POST-MONEY Valuation of $8,000,000. (As we talked about with Cap Tables, you need to leave room for Employee stock and always talk in terms of pre-money. But that’s the basic math.)
Your lead investor will send you a term sheet and, depending on how much she likes to negotiate, her terms will probably be around those numbers (assuming she agrees that you need $2,000,000).
I get into Term Sheets and best practices around those in Part 9, but for now please just plan on raising funds as a priced equity round. You’ll thank me later.
