3 Types of Startup Financing You MUST Know About If You’re Thinking of Raising a Seed Round

Jan 9, 2018

“Venture funding works like gears. A Typical startup goes through several rounds of funding, and at each round you want to make just enough money to reach the speed where you can shift into the next gear.

Few startups get it quite right. Many are underfunded. A few are overfunded, which is like trying to start driving in third gear. I think it would help founders to understand funding better – not just mechanics of it, but what investors are thinking.”

Paul Graham

Partner, Y Combinator

I wanted to start with that quote because I need you to understand that you’re probably not going to get this whole ‘seed funding’ thing right. Even the greats like Paul Graham understand that for most startups raising angel investment and creating terms for that investment is a hard challenge to face.

BUT.

There are things you can do to make sure you don’t royally mess the whole process up. One of those things is ensuring you have a very clear understanding of the different types of startup financing options.

There’s nothing worse (really, I’ve seen it) than going into an investor meeting and having the investor ask ‘so what are the terms’ and having no answer while you turn beat red with shame, stumbling over your words like a 3 year old.

Don’t let that happen to you.

Seed stage investment is harder to get today than it has been in a dozen years. Many investors are just holding their money or investing in later stages where the risk is lower. That means there’s less money to go around for entrepreneurs like me and you, so you MUST be prepared whenever you get the chance to pitch to an investor.

So, below are the three most common types of startup financing you need to know about.

 

Convertible Debt

Sometimes you’ll hear this called a ‘Convertible Note’ but it’s the same thing. This is a loan an investor gives you for your startup. Think of it like a home loan, because a lot of the same terms apply. Convertible Debt (CD) has 4 factors that go into it.

First, there’s the Principle Amount, which is the amount of funding the investor is giving you.

Second, there’s the Interest Rate, usually over 4-5%.

Third, Maturity Date, which is when the Principle Amount plus Interest must be paid in full back to the investor.

Fourth, and most complicated, is the Valuation Cap. Take a deep breath, because this is going to take a minute to understand. So Convertible Debt isn’t done by an investor because they really want to earn 4%+ interest. They could do that with a savings account at the bank. No, they’re doing it because they want that debt to CONVERT to something more valuable when you go raise your Series A. Here’s an example of how this works.

Let’s say you’ve raised $200K with a Convertible Debt with a Valuation Cap of $5M. Awesome, good for you. A couple years later you raise $2M in a Series A round with a $10M valuation. So what happens to that $200K Convertible Debt? The value price per share for the Convertible Debt holders after the Series A event will be the Valuation Cap ($5M) divided by the total amount of shares that were available in the initial seed round when the Convertible Debt was bought.

I’m guessing you’re asking ‘WTF does that mean?’ Yeah, I did too when I first learned about this.  In short it means the Convertible Debt converts to twice as many shares as it would take a Series A investor to buy into. Basically, the Convertible Debt holder’s own for $1 what it would take the Series A investors $2 to buy today.

Confusing? Yes. Important? Yes. So if it’s so complicated why is it done? Because investors love Valuation Caps. It helps them drastically grow the value of their money IF your startup has a big event, like a good size Series A. Can’t say I blame them; you probably wouldn’t make it to the Series A if it wasn’t for them anyway so there’s that.

Despite how complicated it is, Convertible Debt is the most common type of startup financing because investors love it AND it doesn’t lock founders into a solid valuation which is difficult to create at such an early stage.

SAFE

This method is becoming more and more popular but still isn’t nearly as bit as Convertible Debt.  It won’t take me too long to explain this one. It’s the same as Convertible Debt but with no interest rate, no maturity date (when the debt has to be paid back, which Convertible Debt often does), and no repayment requirements (again, something Convertible Debt has).

Yes, you heard that right. SAFE’s are awesome, which is why they haven’t gotten on that quickly. Most of the time you’ll see them from large angel groups, VCs, or accelerators and incubators. Y Combinator is one that’s notorious for them.

The reason they’re more popular with groups like this is because they’re more risky, but these larger and more experienced investors are able to hedge their bets a bit and also have higher success rates because they are very selective with who they invest in.

 

Equity

This is by far the simplest of the financing types but also the least common for seed rounds. It’s also where most startups get in over their head. Equity simply means that you convert your startup’s value to shares, and let an investor straight up buy a piece of it.

You’ll see this type of financing on Shark Tank where those investors buy ‘20% for $200K’ or something.

There’s two major problems with this type of financing for startups though. First, Equity financing relies heavily on the valuation you give your startup, and if you’re very early that can be near impossible to do right. Over value yourself early on then investors in later rounds will be scared off by your lack of a large increase in the valuation once you get to the Series A. Under value yourself early on and you’ll let seed stage investors get way too much bang for your buck, also scaring off future investors.

So what should you do? Avoid it. But if you have to use equity financing try to not give away any more than 25% equity. Also, talk to as many experienced investors and startup mentors as possible to come up with a great valuation.

 

So what should you choose?

Well, that’s hard to say, but you probably won’t have a choice. Negotiating with investors during your first funding round is less like negotiation and more like listening… UNLESS you know what you’re doing. If you’re able to choose then pick SAFE first, then go with a Convertible Debt, followed by Equity.

Want to learn more ins-and-outs of startup funding? Join us for our free webinar and we’ll walk you through how to raise your first funding round in the next 90 days! Just click that nice looking image below.

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