Bridging Startup Runways: Inside Convertible Debt Instruments

Driving growth, aligning investors.

Introduction

Securing startup funding is a challenging but necessary step for early-stage companies to get off the ground. However, arriving at a valuation during the initial risky stages can be incredibly difficult. Convertible instruments have emerged as a solution that allows startups to bridge the gap between funding and future-priced equity rounds.

Convertible notes and SAFEs (Simple Agreements for Future Equity) allow companies to raise funds without placing an exact value on the business. Instead, the investment converts to equity later, upon events like a future financing round. This creative approach unlocks capital quickly while postponing tricky valuation conversations to a more appropriate time.

This article will explore the mechanics and benefits of convertible notes and SAFEs for startups seeking fundraising alternatives. This overview includes how each instrument works, key terms and conditions, ideal users, and real-world examples of convertible securities enabling startup growth. We will also discuss some considerations around risks and investor perspectives when weighing these financing options. By the end, you'll fully grasp how convertible instruments fill a crucial niche in the early-stage funding landscape.

Convertible Instruments

Convertible notes and SAFEs share similarities in bridging the gap to priced equity rounds but have distinct structures. Convertible notes are short-term debt instruments with a maturity date and interest rate. The investor loans money to the startup, which then converts to equity under agreed-upon terms in the future. SAFEs, on the other hand, are not structured as loans. They are contractual agreements where the investor pays cash to the startup in exchange for future equity under predetermined terms. Both provide startups with quick access to capital while postponing valuation negotiations. Now, let's explore each of these instruments more closely.

Convertible Notes: How they Work & Benefits

Convertible notes provide a flexible funding approach through a short-term debt structure that later converts into equity ownership. Investors provide capital to a startup in exchange for a promissory note that functions like a loan. This loan contains specific terms detailing how and when it will convert into an equity stake based on certain trigger events.

Unlike traditional loans, convertible notes include stipulations that the principal and accrued interest transform into equity shares in the company rather than getting paid back in cash. The maturity date, generally between 1-2 years, determines the latest possible repayment date before the note defaults. However, the real intention is for conversion to occur well before maturity, usually prompted by priced funding rounds that establish a company valuation. This structure neatly postpones trickier valuation conversations to a more appropriate timing.

Convertible notes carry an interest rate, typically around 5-8%, which accrues on the principal over the loan term. This structure incentivizes startups to trigger conversion events before maturity and prevents excessive interest costs from accumulating. Upon conversion, the unpaid principal and interest balance transform into an equity ownership percentage per the terms.

For startups, convertible notes offer a faster way to raise capital than priced equity rounds. They can quickly secure funding to extend their cash runway and build more value before facing dilution. The deferred pricing also enables startups to improve their valuation before the conversion event, minimizing premature dilution of ownership. With less complexity than pricing equity upfront, convertible notes require far less legal work and negotiations to wrap up.

Standard economic terms that dictate the conversion rules include a valuation cap and a discount rate for investors. The valuation cap sets the maximum company valuation that applies upon conversion to equity. Upon conversion, the discount rate gives investors a certain percentage of the reduced stock price. These terms reward investors for their early risk while incentivizing startups to grow their value before the conversion triggers.

SAFEs: How they Work & Benefits

SAFEs (Simple Agreements for Future Equity) emerged as an evolution of convertible notes, simplifying the terms to only what is essential. A SAFE investor provides capital to a startup in exchange for a contractual right to receive equity later, typically in a priced round establishing a valuation.

SAFEs were pioneered by famed startup accelerator Y Combinator in 2013 through an open-sourced online form. This templatized approach simplifies early fundraising discussions and provides a balanced, founder-friendly instrument. Since its introduction, Y Combinator's SAFE template has become a widely adopted standardized contract used by thousands of startups and investors in early fundraising rounds across the ecosystem. The broad familiarity and acceptance of YC's forms reinforce the flexibility and accessibility of SAFEs.

Unlike notes, SAFEs do not have a maturity date or repayment obligation. Rather than functioning as debt, they operate on flexible terms for future equity ownership. No interest accrues and startups do not have a due date to deliver returns outside investor expectations or company needs. This structure removes time pressure and eases cash flow responsibilities before significant milestones.

Conversion to equity still occurs at an eventual trigger event but without the urgency of repaying interest or principal to SAFE holders. Valuation caps and discounts incentivize startups to hit growth metrics that reward investors for their early risk. But no default risk requires capital or diluted equity repayment if progress stalls. The contracts remain in place for conversion in the future.

For very early-stage startups, SAFEs provide all the same benefits of convertible notes to access capital quickly without prolonged valuation negotiations. Streamlined SAFE terms also involve lower legal costs than convertible notes or priced equity rounds. The removal of debt obligations enables full attention on growth rather than interest payments coming due.

On the investor side, SAFEs do incur more risk than notes or equity in some regards. With no due dates or recourse options upon default, investors must accept 100% risk of total loss until conversion triggers. Compared to convertible notes, SAFEs offer less incentive for startups to activate conversion events within an explicit timeframe.

But for many seed investors, backing experimental ideas has inherent risk already. SAFEs align interests for all parties to pursue growth rather than short-term returns, with conversion rights waiting until significant progress unlocks new funding. In fast-moving startup environments, founders and investors opt for flexible SAFEs to skip unnecessary complexity.

Bridging the Runway

Convertible notes and SAFEs both serve a vital purpose for early-stage startups seeking to defer pricing conversations during times of uncertainty. They buy companies time to build capabilities and achieve milestones that support better valuations down the line. 

The most natural users are pre-seed and seed-stage startups working to prove their vision before facing external pricing pressure. Companies still developing products, seeking product-market fit, or demonstrating early traction benefit significantly from tapping into capital without intricate valuation ceilings at such fragile points.

Likewise, startups caught between funding rounds depend on convertible instruments to provide a runway until completing a future priced round. Rather than accepting terms amidst downturns, convertible securities allow startups to access immediate financing and wait for improved environments before pricing. This strategy helps prevent dilution and existential threats during temporary headwinds.

Dynamic startups focused on speed, and flexibility depends on convertible instruments before growth trends solidify valuation potential. Notes and SAFEs enable ambitious founders to control their destiny in the interim, regardless of external conditions. The contracts provide upside when executed well while buying crucial time between performance milestones rather than locking premature valuations.

Essential Terms

Convertible notes contain several significant economic and governance terms that impact startup founders and investors. Understanding typical ranges for these terms enables strong negotiation positions and tradeoff assessments. Note: SAFEs do not have maturity dates, mandatory conversion thresholds, or interest rates.

Some of these issues are complex, and you should always consult a legal professional to support strategies and negotiations.

Maturity Date: Typically set between 18-24 months, with longer timeframes better for startups, as it delays repayment risk. However, investors resist extended dates over 36 months. This resistance is likely due to the increased risk and prolonged uncertainty regarding the return on their investment. Longer maturity dates can be better for startups because they provide more time to reach a conversion event, such as a future financing round, which would prevent the need for repayment. Founders should know that these maturity dates are a crucial negotiation point, and ranges can vary. 

Mandatory Conversion Threshold: Refers to the dollar amount of new financing that would automatically trigger outstanding convertible notes to convert into equity shares. This conversion from debt to equity is critical in a startup's lifecycle.

Setting a low mandatory conversion threshold favors startups, enabling notes to convert at early, smaller funding rounds to clear debt off the cap table. A threshold of $1 million would allow conversion even at an early seed extension round. Meanwhile, investors generally push for higher mandatory conversion thresholds closer to a complete Series A or beyond, like $5 million. This higher level protects their debt holder status until company traction and value are proven. For example, a startup could set a $2 million mandatory conversion threshold with the intention that their Seed+ round of that size would convert notes. However, if Seed+ stalled and a $3 million Series A ultimately closed first, the conversion would still happen regardless of the initially envisioned sequence. Hence, keeping terms flexible without specifying round names proves essential.

The threshold represents a strategic negotiation point reflecting risk tolerance on both sides. Startups don't want to owe growing interest, while investors want assurances before subordination. The goal for startups is aligning conversion to strategic inflection points rather than solely minimizing the threshold dollar figure. The threshold should be designed to trigger conversion at an opportune moment in the company's development.

Interest Rates: Convertible notes carry interest rates, usually 5-8% per year, accumulating on top of the original principal amount loaned. This interest accrues for the note's term before conversion, typically 18-24 months. 

Startups aim to negotiate the lowest viable interest rates possible. Any unpaid interest gets added to the outstanding balance and converts to equity shares alongside the original principal. Hence, lower interest minimizes dilution from extra converted value. 

However, going below 5% risks additional tax burdens from triggering what the IRS calls "below-market interest rates" under IRC Section 1272(a). These "bargain" rates require special filings and can complicate taxes. Most investors avoid this by setting rates slightly above Treasury levels, which currently fall between 3-4%. A 5-8% convertible note rate provides a reasonably discounted but IRS-compliant return.

For example, a startup raising a $500,000 convertible note could agree to a 6% annual rate, accumulating $36,000 in interest expense over an 18-month term. Upon conversion to equity, repaying $536,000 converts to more shares and higher dilution than repaying just the $500,000 principal. So minimizing interest owed aids the company.

Valuation Cap: Establishes a ceiling for the future price per share upon conversion to equity. Caps can anchor later priced rounds, so higher is better for founders to maximize valuation potential. Valuation caps are a critical term in convertible notes and SAFEs as they set a maximum valuation at which the investment can convert into equity. This term rewards early investors for taking on more risk by providing them with a lower price per share if the company's valuation increases significantly during a priced equity round.

However, founders should beware of restrictive valuation caps that seem artificially low relative to growth milestones or market conditions. Shallow caps can negatively impact future priced rounds, as new investors balk at providing massive gains rather than reasonably sharing upside. Disproportionate rewards require compelling justification around projected revenues and margins - a problematic position for most young startups. Likewise, once embedded, low valuation caps can anchor later negotiations or set standards new investors expect to perpetuate without context behind them. Lower caps unintentionally harm founders by distorting subsequent conversations.

Thus, setting valuation caps warrants a balanced, defensible approach. Building a solid case for significant upside can better align incentives for new capital without undercutting founders prematurely. For founders, a valuation cap can be a double-edged sword. A low cap can lead to a more significant dilution of their ownership if the company's valuation at the next round is much higher than the cap. Conversely, a high cap can minimize dilution but may be less attractive to investors looking for a significant return on their early investment.

Discount Rates: Give early investors a percentage reduction on the price per share at which their convertible securities convert into equity. This discount compensates investors for their early support and the associated risks. The discount rate directly impacts the conversion price, with a higher discount leading to a lower conversion price and potentially more significant dilution for existing shareholders, including the founders. Founders must consider the discount rate carefully and negotiate terms that balance investor incentives with minimizing dilution.

Investor Protections

Convertible note investors often negotiate for special rights and provisions to protect their interests in the company before conversion and mitigate risks. Common protections include:

• Voting Rights: Gives investors a designated number of votes on future company matters. This condition provides some control before officially becoming shareholders.

• Board Seats: Guarantees investor's board representation to oversee operations and critical decisions. Otherwise, they must wait until conversion triggers to elect directors.

• Antidilution Provisions: Issues additional shares to investors if later equity rounds have lower valuations, protecting investor % share from dilution.  

• Note Amendment Approvals: Requires specific investor consent for changes to the note's terms, protecting existing investors as more get added.

• Information Rights: Grants investors access to financial statements and other company data that helps monitor investment performance.

These provisions favor early investors but limit flexibility for companies to operate independently before conversion. Startups may concede select protections to incentivize investment while preserving control where possible. Carefully negotiating these terms for balanced risk-reward helps prevent excessive founder dilution or investor control. Understanding tradeoffs enables startups to customize notes to their context and projected milestones. Consulting specialized legal counsel to navigate these nuances proves critical for ideal agreements.  

Implications and Tradeoffs

While convertible instruments grant immense flexibility, they also come with subtle nuances to weigh for both founders and investors. Rather than a simplistic financing panacea, strategic utilization requires evaluating implications unique to deferred pricing structures. When assessing these instruments, the top concerns cover conversion dynamics, governance control, investor incentive alignment, and proactively balancing founder versus funder interests over lifecycles. Here are critical aspects for leaders to consider when determining optimal usage.

Impact on Conversion Price and Dilution

When a conversion event occurs, such as a Series A financing, the convertible securities will convert into equity. One determines the conversion price by either the valuation cap or the discount rate, whichever results in a lower price per share for the investor.

For example, if a startup has a valuation cap of $5 million and raises a Series A at a $10 million valuation, the early investors' convertible securities would convert at the $5 million cap, resulting in more shares issued to them and more significant dilution for the founders. If the same startup has a 20% discount rate, and the price per share in Series A is $1.00, the early investors would convert at $0.80 per share, again resulting in more shares for the investors and more dilution for the founders.

The key for founders is to set valuation caps and discount rates that reward early investors fairly while protecting their ownership stake. Founders should also be aware that these terms can set a precedent for future financing rounds and may influence the terms offered by new investors.

Risks and Downsides 

The deferred pricing of convertible notes and SAFEs represents one of their primary risks. If upcoming valuation events set the conversion price extremely low, early investors gain outsized ownership and dilute founders deeply. Banking on projections rather than present evidence contains inherent uncertainty.

Convertible notes also carry risks of reaching maturity without meeting conversion triggers. If the maturity date arrives and no conversion event has occurred like a future priced round, several problematic scenarios unfold for the startup:

1. The noteholders can demand full repayment of principal and accumulated interest, which early-stage startups typically cannot accommodate due to limited cash flow, especially during periods of market uncertainty.

2. If unable to repay the matured notes, the company would default, meaning noteholders could assume board control or even force bankruptcy/dissolution. This liquidation threat further diminishes startup survival chances.

3. To avoid the above outcomes, startups often accept unusually dilutive terms in subsequent rounds to clear the notes off their cap table, drastically impacting founder equity and company growth trajectory from massively diluted shares.

Essentially, convertible notes must convert before maturity, or the ticking time bomb severely hampers startup prospects while empowering note investors. Setting maturity dates further out potentially mitigates but does not eliminate this risk. This threat underscores the need for founders to drive purposeful growth and trigger conversion events well before debt burdens overwhelm the runway.

For SAFEs, while removing debt reduces urgency, the open-ended timeline allows endless accumulation of investors lacking governance control. This condition could devalue future investment or leave startups weighing downside terms to clear the cap table.

When determining the amount to raise through convertible notes or SAFEs, startups should aim not to exceed 20% of the expected future Series A round into which they will convert. Given the inherent uncertainty in projecting the size and timing of Series A rounds, maintaining convertible raises under $1-1.5 million can help mitigate the risk of excessive ownership dilution upon conversion.

For instance, a startup raising $500K through a convertible note in anticipation of a $3 million Series A in 12 months might find that this investment only constitutes 5% of an unexpectedly large $10 million round at conversion, thus minimizing dilution. Conversely, raising $2 million with the expectation of it being a significant portion of a Series A round could lead to unintended high dilution if the actual Series A round is not substantially more extensive than anticipated.

Minimizing convertible raises allows founders to retain more flexibility in future financing rounds while using these instruments to bridge immediate capital needs. Unless there's clear visibility into securing a sizable Series A of over $8 million, limiting the amount converted through these instruments can protect against unpredictable dilution and maintain founder equity.

Convertible notes also involve more involved legal processes and representations than SAFEs to document the debt relationship between investors and startups. Convertible note offerings usually require extensive note purchase agreements covering investor protections, risk factors, disclosures, and securities compliance. Startups must also make contractual promises around repayment capabilities, registration rights, and business continuity to provide noteholders sufficient recourse. These extra diligence, compliance, and liability considerations involve higher administrative and legal costs than a SAFE's simplified template. The heightened complexity extends transaction timelines as well.

Investor Perspectives

From an investor viewpoint, convertible instruments lack protections compared to priced equity rounds. With SAFEs, investors have no voting rights, board seats, or ability to negotiate terms until conversion events occur. They depend on startups to determine governance and lead-priced rounds.

Convertible securities transform into less preferential share classes than new investors upon conversion. This condition means early convertible investors end up with shares of a lower seniority tier. New investors can set the most favorable terms for themselves in priced rounds. As a result, major governance influence shifts to these new leaders contributing significant primary capital unless the convertible economics prove significantly better. New large-check investors gain control through favorable share class structures after conversion hits. Seed investors via convertible notes depend intensely on founders negotiating deals, limiting this control imbalance during major future rounds.

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Alternative Funding Sources

For many startups, market uncertainty or challenges in finding alignment make priced equity rounds ill-advised at fragile stages. However, those with leverage and visibility into growth may immediately set valuations to secure better controls. There are several other options for startups to consider. Venture debt, or even bootstrapping development, serves as an alternative that provides runway extensions without handing over eventual governance influence. Banks offer debt products for high-trajectory startups as well. Additional funding alternatives to convertible notes and SAFEs include:

Equity Crowdfunding Platforms

Online equity crowdfunding platforms provide venues for raising small amounts of capital from many backers. While still equity stakes, the micro-investment scale and pool of investors differentiate from typical VC. For example, SeedInvest and Republic enable startups and investors to connect. Companies offer equity at set valuations in return for capital from retail participants. These sites facilitate outreach and transactions.

Peer-to-Peer Lending 

P2P lending networks like LendingClub allow retail lenders to finance debt based on marketplace algorithms and credit risk models. Though traditionally focused on consumer credit, small business products have emerged with better expense optimization than convertible notes. Interest rates float based on models rather than negotiations.

Fintech Loan Providers

Financial technology lenders utilize data-driven approaches to underwrite early-stage startup loans with attractive flexibility. Options from firms like Stripe and Clearbanc finance startups through loans pegged to revenue share or other creative structures beyond convertible notes. AI informs customized products. The expanding fintech ecosystem opens creative financing alternatives to bridge startup growth outside conventional venture capital and debt structures. Founders should explore the full range of optimized emerging products fitting their needs.

Conclusion

Convertible notes and SAFEs enable startups to tap into crucial capital to fuel growth by delaying tricky pricing conversations to more appropriate times. Instead of struggling to set valuations amidst uncertainty, convertible instruments allow founders to bridge financing rounds while minimizing premature dilution.

For early seed-stage companies still gaining traction, flexible structures like SAFEs focus squarely on building products and making progress rather than getting distracted by financial engineering. Convertible notes also supply working capital to development-stage ventures without diverting energy towards negotiating terms sheets. 

Investors in startups fully expect risk, so providing capital through accessible vehicles aligned for speed makes sense. The most successful investors think long-term, caring more that convertible dollars empower ambitious founders to reach inflection points. Hitting milestones unlocks future rounds with less dilution as startups gain maturity. 

Of course, convertible instruments have risks if conversion valuations grossly outweigh the priced round potential. Savvy startups project accordingly and leverage the deferred pricing to build underlying business value rather than chasing paper gains. Precise alignment and expectations help minimize surprises or harm.

While convertible notes and SAFEs serve crucial bridging purposes, overreliance can needlessly defer transparent conversations around core business fundamentals. Once initial traction validates the model, priced equity rounds or structured debt facilities better incentivize long-term governance and growth planning.

Ultimately, the prudent leveraging of bridging vehicles today paves the road for tomorrow's iconic companies built on ethical alignment between shareholders and leadership. Convertible instruments enable founders to access essential capital while retaining control - a privilege visionary must match with sustainable execution if they aim to advance industries fundamentally.