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February 01st, 2021

2/1/2021

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Choosing the Right Investment Structure for Financing a Start-Up:
Equity Investments, Convertible Debt, and SAFEs

 
Choosing the right financing option for a company in its early stages will depend on the unique needs of both the start-up and its investors. The most common investment structures used for financing early-stage companies include: equity investments, convertible debt instruments, and SAFEs. Advantages and disadvantages of these different investment instruments are outlined below and should be weighted carefully so as to select the financing option that best meets both company founder and investor needs.  
 
 EQUITY INVESTMENTS
An equity financing involves investors directly purchasing a certain percentage of capital stock from the company based on the company’s current valuation. This could be in the form of purchasing either common or preferred shares in the company.
 
Advantages:
  • A start-up company may prefer an equity investment over debt because investors cannot “call” the equity investment the way they can “call” debt to be repaid upon maturity. Many start-ups don’t want to worry about having enough cash on hand to pay out debts at inconvenient times in its early lifecycle.
  • Equity looks better than debt on the balance sheet of a start-up company in its early stages, which makes the company more attractive to later investors.
 
Disadvantages:
  • Depending on the complexity of the investment, equity agreements often require higher legal fees to negotiate a wide range of terms.
  • Equity investments lock in a company’s valuation at an early stage in a growth company’s life cycle, which means less flexibility for negotiating the valuation of the company with subsequent investors.
 
 CONVERTIBLE DEBT/CONVERTIBLE NOTES
Convertible debt, or “convertible notes”, can sometimes be a good alternative to early-stage equity investments. Convertible debt essentially allows investors to loan money to the company in exchange for a future right to have their debt converted into shares of the company’s stock. The percentage and amount of shares the debt will convert into is determined by the terms of the agreement and is usually converted in line with the valuation given to the company in its next equity financing.
 
Advantages:
  • Convertible debt involves fewer negotiation terms and less paperwork, which drives down both legal costs and deal timelines, allowing the company to put that money into the business instead of into lawyers.
  • Start-ups might prefer convertible debt financing in its early stages because it delays the valuation of the business until later in the company’s lifecycle. This provides the company with more flexibility in negotiating their later-stage financing rounds.
  • For investors, the convertible debt note offers a fixed interest rate of return and some priority to be paid out before common shareholders if the start-up fails.
 
Disadvantages:
  • The main disadvantage of convertible debt financing resides in the nature of debt itself; that is, the investors have the right to call the debt upon its maturity date. An early-stage company will often not have the cash flow on hand to repay investors if the debt is called. That said, in practice, few investors call in convertible debt notes as they are meant to be investments; therefore, most investors will simply renegotiate the investment when the term is up.
 
 SAFEs
SAFEs (Simple Agreement for Future Equity) were first developed in Silicon Valley as a way for venture capital investors to be able to quickly put money into a start-up without the burdensome negotiations that equity financing often entails. SAFES were created specifically to avoid the debt features and repayment obligation of convertible debt notes.[1] A SAFE, like a convertible note, does not give the investor stock in the company, but rather is a promise for future stock in the company on occurrence of the next equity financing round. Unlike a convertible debt note, a SAFE is not debt, but something more akin to an equity call on options or an equity warrant.[2]
 
Advantages:
  • For start-up founders, SAFES can be beneficial because they do not act like debt instruments and therefore do not accrue interest or have a maturity date when they can be called by the investor.
  • SAFEs are usually relatively easy to negotiate and quick to implement.
  • Like convertible notes, SAFES do not require the company to adopt a valuation of the company early on, thereby leaving more flexibility for negotiating future financing rounds.
  • SAFES keep debt off the balance sheet of an early-stage company.
 
Disadvantages:
  • It has been suggested by some scholars that SAFEs are a poor match for financing conditions in Canada.[3] Canada does not have the same access to institutional venture capital like that of the Bay Area. In Canada, there may be no subsequent financing available after a SAFE investment. If financing is available, it may come from less sophisticated retail investors who will then set the valuation of the company that SAFE holders will have to follow.
  • SAFEs provide no fixed rate of return and no real leverage to re-negotiate financing terms. The priority afforded debt over equity at least provides investors with some protection in the early stages of their investment because they can call the debt and have some leverage to re-negotiate terms. In contrast, SAFEs often lack this protection because they act more like an equity warrant and have no maturity date.
 
Whatever investment structure is utilized, it is important to know the pros and cons of each investment option, as a wrong choice of financing in the early stages of a growth company can have unforeseen consequences later in the company’s lifecycle. It is also advised to seek consultation with legal professionals so as to receive tailored advice for specific company and investor needs.
 
   ________________
[1] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274.
[2] MARPE, “Hey SEC - SAFEs are Equity, not Debt!” (26 June 2017), online: <https://marpefinance.com/blog/HeySECSAFEsareEquitynotDe-2017-06-26>
[3] Bryce Tingle, Start-up and Growth Companies in Canada (LexisNexis Canada Inc., 2018) at 274.
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