The Various VC Funding Instruments

When considering the deal structure (type of security) for closing venture rounds, we usually choose between three main options: Preferred Shares, Convertible Debentures/Notes, and SAFEs. I'll provide a high-level summary of the differences between these options so you, as a founder, can enter these discussions well-informed.

First, let's touch on the "secret" fourth option (which isn't really an option): Common Shares.

Common Shares

Common shares are the basic unit of ownership in your company. They are straightforward, representing an ownership stake calculated by dividing the number of shares held by the total number of common shares outstanding. All common shares are identical, meaning one common share is the same as another.

Companies often have Series A and Series B Common shares. Series B might lack voting rights and be used for the employee stock option pool (ESOP), but both series have the same economic claim on the company's value.

I call them "the secret fourth option (that's not really an option)" because sophisticated investors typically avoid them. While you might find investors in less developed markets who will buy them, professional investors, who can open doors for you, usually won't. This is because other securities offer features that protect against losses, which investors use to manage risk in their portfolios.

Despite this, common shares remain the foundational unit of ownership. That's why your cap table includes terms like "Common Share Equivalent" when referring to preferred shares or convertible instruments. These are just ways to translate invested capital into ownership.

Preferred Shares

Preferred Shares are often considered the "gold standard" in venture financing because they provide a balance of risk mitigation for investors and flexibility for founders. They grant certain rights and preferences to investors that are not available to holders of common shares, which makes them an attractive option for both parties in a deal.

Here’s why they are favored:

1. Liquidation Preference
   One of the key advantages of Preferred Shares is the liquidation preference. This feature ensures that investors are paid back their initial investment (and sometimes more) before any common shareholders receive proceeds in the event of a liquidity event, such as a sale, merger, or liquidation of the company. Investors may receive their original investment or a multiple of it, depending on the terms negotiated. This helps mitigate downside risk for investors, making Preferred Shares more appealing to those looking to protect their capital.

2. Dividends
   Preferred shareholders may also be entitled to dividends, either as a fixed percentage of their investment or as discretionary payouts decided by the board. These dividends can be cumulative (meaning they accrue if unpaid) or non-cumulative. While most early-stage venture investments don't pay dividends, these dividends simply accrue until it is time to convert the preferred shares into common equity (usually in association with an acquisition).

3. Conversion Rights
   Preferred Shares are typically convertible into common shares, often at the investor’s discretion, especially during an exit or a public offering (IPO). Conversion is usually one-to-one but can also involve more complex formulas if anti-dilution provisions are included (more on that below). This flexibility allows investors to share in the upside if the company grows significantly in value.

4. Anti-Dilution Protection
   Anti-dilution provisions protect investors from their ownership percentage being significantly diluted in subsequent rounds of funding where the company might issue shares at a lower price (down round). The most common mechanisms are "weighted-average" and "full ratchet" anti-dilution adjustments. These terms can influence how much ownership founders retain after multiple rounds of financing, making it crucial for founders to fully understand their implications.

5. Voting Rights
   Preferred shareholders often have special voting rights compared to common shareholders. These can range from the ability to elect certain board members to veto rights on major corporate decisions, such as a new funding round or company sale. This provides investors with a level of control over the company’s direction, helping them safeguard their investment while allowing the founders to operate the business.

6. Participation Rights
   Sometimes Preferred Shares come with “participation” rights, where investors not only receive their liquidation preference but also share in the remaining proceeds with common shareholders. This is known as a "participating preferred" structure and can significantly impact the proceeds available to common shareholders. There are also variations like “capped participation,” which limits how much more investors can receive after their liquidation preference.

While these features make Preferred Shares attractive to investors, they are also a useful tool for founders. By negotiating the terms thoughtfully, founders can raise significant capital without giving up too much control or diluting their ownership early on.

Convertible Debentures/Notes

Convertible debentures (or convertible notes) are debt instruments that convert into equity upon certain triggering events, usually a subsequent equity financing round or upon reaching maturity. They are widely used in early-stage fundraising, especially when the company and investors need a quick, flexible solution before determining a formal valuation.

Key features of convertible debentures include:

1. Debt with an Equity Option
   Convertible notes are initially structured as debt, meaning the company borrows money from investors and promises to repay it, usually with interest, at a set maturity date. However, instead of repaying the debt in cash, the debt converts into equity (typically Preferred Shares) when the company raises its next round of funding. This conversion typically happens at a discount to the next round’s share price, providing early investors with an upside for their risk. This is why, while Convertible Debentures technically are debt, none of the parties involved in the transaction view it as such since they all assume that it'll end up converting into equity.

2. Discount Rate
   Since convertible notes delay setting a valuation, investors are rewarded for their early risk by receiving a discount on the price of shares in the next round. For example, if the discount is 20% and the next round is priced at $1 per share, noteholders can convert their notes into equity at $0.80 per share. This ensures early investors receive more shares for their money compared to later-stage investors.

3. Valuation Cap
   A valuation cap is another mechanism used to reward early investors. It sets the maximum pre-money valuation at which the note will convert into equity, regardless of how high the actual valuation is in the next round. If the company’s valuation exceeds the cap, the noteholders convert at the lower valuation cap price. This provides early investors with more equity if the company performs well. Be sure to recognize how this is different than a valuation set as part of equity financings (read more about this distinction here).

4. Interest Rate
   Convertible notes typically accrue interest, which can range from 2% to 8%, depending on market conditions and risk appetite. While early-stage startups rarely repay interest in cash, the accrued interest is often added to the principal amount and converts into equity along with the original note when a financing round occurs.

5. Maturity Date
   Convertible notes have a maturity date, usually 12 to 36 months, at which point the company is expected to either raise an equity round (triggering conversion) or repay the debt. If the note matures without a financing event, noteholders typically have the option to demand repayment or convert their debt into equity, often at a price based on a pre-agreed formula. This adds a level of risk for both parties, particularly if the company doesn’t raise the anticipated next round before the note matures.

Convertible notes offer flexibility and speed but can become complex, particularly with multiple investors and varying terms like discount rates and valuation caps.

SAFEs (Simple Agreement for Future Equity)

SAFEs, or Simple Agreements for Future Equity, are another common alternative for early-stage financing. Created by Y Combinator, SAFEs offer a more founder-friendly, simplified alternative to convertible notes. While they share some similarities, SAFEs do not carry debt-like features, making them more straightforward for both investors and founders.

Key features of SAFEs include:

1. No Debt, No Interest, No Maturity Date
   Unlike convertible notes, SAFEs are not debt instruments. This means they don’t accrue interest, and they don’t have a maturity date, eliminating the risk of the company needing to repay investors if a future funding round doesn’t materialize. This provides more flexibility for founders, as they’re not under pressure to raise funds or face a debt repayment timeline.

2. Valuation Cap and Discount
   Like convertible notes, SAFEs often include a valuation cap and a discount rate. The valuation cap sets a ceiling on the company’s valuation for conversion purposes, and the discount allows investors to convert at a lower price in a future round. These terms ensure that early investors receive a higher equity stake for their risk, but without the added complexity of interest accrual or a debt obligation.

3. Automatic Conversion
   SAFEs often automatically convert into equity when the company raises a priced round (typically Preferred Shares). There’s rarely any ambiguity around the timing of conversion, and the SAFE will convert into shares based on the valuation cap or discount—whichever provides the investor with more favorable terms.

4. No Repayment Obligation
   Because SAFEs are not loans, they don’t need to be repaid. This provides more flexibility to early-stage startups, as they can focus on building their business without worrying about cash reserves for debt repayment. However, for investors, this structure means they’re fully dependent on the company's future equity round to realize any return on their investment.

5. Simplicity and Standardization
   SAFEs are designed to be simpler than convertible notes, often using standardized legal documents with fewer variables. This reduces the cost and time required to close early-stage funding rounds, making SAFEs a popular option for founders who want a quick, hassle-free fundraising process.

While SAFEs provide significant advantages in terms of simplicity and flexibility, founders should be cautious about issuing too many SAFEs or stacking SAFEs with different terms, as this can lead to unpredictable dilution in future rounds. As with any financing structure, the balance between founder control and investor protection needs careful consideration.

If I can give founders any single piece of advice that will save them some of the coldest showers there are, it's to always ensure they keep their convertibles structured similarly (not including the value of the conversion cap, of course) and always understand how these terms interact and the potential impact on future dilution.

Disclaimer: The information provided in this post is for general informational purposes only and does not constitute legal or financial advice. I am not a lawyer, and the insights shared here are based on my experience as a venture investor. Founders should consult with a qualified legal professional who can provide guidance tailored to their specific circumstances before making any decisions related to deal structures, fundraising, or equity terms. Always seek professional advice when navigating legal documents and agreements.