Recommended
Recommended
More Related Content
Featured
Featured (20)
Startup Grind Presentation_KISS, SAFE or Convertible Note (091322).pdf
- 1. KISS, SAFE, or Convertible Note? Understanding Early-Stage Financing Instruments For Startup Grind September 13, 2022 • Presented by Gabriel S. García
- 2. w: djrgarcia.com Deborah J. Rotenberg STAKEHOLDER / CEO Allow me to introduce myself… GabrielS. García Shareholder / Chief Financial Officer DJR García, A Professional Corporation I amuniquely positionedto counsel startups businesses because: • I have a tax law degree which helps guide clients’ decisions based on potential tax liabilities • I have worked in Silicon Valley as a private equity/M&A attorney • I have experience in a Fortune 100 legal department • I have started three of my own businesses
- 3. w: djrgarcia.com w: djrgarcia.com Overview of early-stage financing instruments SAFE KISS Convertible Notes Mistakes startups make when issuing equity Why a professional services team is a must-have Legal counsel Accountants Others? Agenda
- 5. w: djrgarcia.com Basic concept The investor provides funding to the company in exchange for the right to convert its investment to equity upon some future event When an equity round is raised and preferred shares are issued, the investor will receive shares in the subsequent offering, often at a discount to the price that other investors pay in that offering. Rewards first-in-time investors by “getting in early” w: djrgarcia.com
- 6. w: djrgarcia.com Valuation cap vs. discount Valuation cap – provides a maximum ceiling of the company’s valuation at which the convertible instrument investment will convert, regardless of the valuation determined by the priced round investors in the equity financing. • Val.Cap=$5M butpricedroundvaluationis$8M;convertibleinvestmentconvertsasthough itisat$5M Discount – provides for the convertible instrument investment to convert at a discounted price per share that is less than the price per share for the priced round investors in the equity financing. • 20%discountmeansifpricedroundinvestorsarepaying$1.00/share,convertibleinvestmentconvertsat$0.80/share w: djrgarcia.com
- 7. w: djrgarcia.com This is the most common rationale as early-stage companies donot have a long enough track recordto provide reliable data for corporate valuation. Company valuation hard to determine Rationale for using convertibles Investors whobelieve in your company will probably never get a better priceper share than through an early-stage convertible instrument. Opportunity for the largest discount Convertible instruments are often usedin friends and family rounds because these are the investors whobelieve in your company the most. You have a team of “believers” Relatively easy documentation 01 02 03 04 Y Combinator, Startup 500, and other startup accelerators have standardized some early-stage instruments allowing for consistent modeling in investment and lower legal costs.
- 8. w: djrgarcia.com SAFE (Simple Agreement for Future Equity) w: djrgarcia.com SAFE note converts automatically to preferred stock as soon as an equity round takes place. The price of the conversion is lesser of the valuation cap or discount if it is mentioned in the SAFE document. If company fails prior to conversion, investor gets a cash payment that is equal to the SAFE purchase price. Participation right after the next equity funding round. Most Favored Nations clause is not standard but can be included. Each SAFE note can be tailored as per the deal made with the investor.
- 9. w: djrgarcia.com KISS (Keep It Simple Security) w: djrgarcia.com Can be an equity KISS or a debt KISS: Equity: Cap, Discount, no repayment, no interest vs. Debt: Cap, Discount, accrues interest, repayable at maturity KISS converts automatically to preferred stock as soon as an equity round of a new investment above the specified amount occurs (e.g., $1,000,000 threshold). If company fails prior to conversion, investors receive a cash payment equal to 2X the purchase price, plus accrued interest or convert KISS into common stock at the valuation cap. Participation in all future equity funding rounds. Most Favored Nations clause is standard. All KISS investment terms are identical.
- 10. w: djrgarcia.com Convertible notes w: djrgarcia.com Interest: While the convertible note is in place, the invested funds earn a rate of interest like any other debt investment. The interest in not typically paid in cash, but accrued, which means the value owed to the investor builds up over time. Maturity Date: Convertible notes carry a maturity date, at which the notes are due and payable to the investors if they have not already converted to equity. Some convertible notes have an automatic conversion at maturity. Convertible Note Purchase Agreement: Board approves of a series of convertible notes, up to a certain debt ceiling, on identical terms by which investors can invest at different times without needing to issue separate agreements to each. Additional rights: Usually convertible notes contain both MFN clauses and pro-rata rights.
- 11. w: djrgarcia.com MFNs and Pro-rata Rights w: djrgarcia.com MOST FAVORED NATIONS If a company issues additional notes in the future with better terms, then the investor can elect to exchange their convertible security with the one that has better terms. Example:astartupissuesconvertiblenoteswitha20% discountandayearlater,itissuesonewitha30%discount. Here,theinvestorwiththe20%discountcanreceivethe 30%discountwiththisclause. PRO-RATARIGHTS Pro-rata right, also called participation right, is a right that is at times included in the convertible securities, where the investor is allowed to invest additional funds during the next priced round. Normallyallowedonlyatthepricethatispaidbythenew investorsandnotasperthediscountedconversionprice.
- 12. w: djrgarcia.com Additional resources w: djrgarcia.com Lots of resources out there to see specific examples of how convertible financing instruments work. One of the best is Kirsty Nathoo’s presentation at Y Combinator: https://www.ycombinator.com/library/6m-understanding-safes-and-priced- equity-rounds
- 13. w: djrgarcia.com Frequent Mistakes When Issuing Equity w: djrgarcia.com
- 14. w: djrgarcia.com Not being due diligence ready w: djrgarcia.com Having corporate documents completed, signed(!), and delivered in a timely fashion to investors is a case of first impression.
- 15. w: djrgarcia.com Not reading legal documents w: djrgarcia.com If you don’t have legal counsel, you should be reading every word of every legal document you’re signing. Even if you have legal counsel, don’t simply rely on the attorney’s advice without having a conception of what the documents do.
- 16. w: djrgarcia.com Issuing too many convertibles w: djrgarcia.com Convertible investment instruments are very handy for early-stage financing but beware of issuing too many because they only dilute the founders and not the preferred equity investors.
- 17. w: djrgarcia.com Cap table misrepresentation w: djrgarcia.com Because the convertible instruments’ conversion into shares will depend on factors that are unknown at the time it is issued, there’s no absolute way to represent the convertible instruments in your cap table.
- 18. w: djrgarcia.com Importance of a Professional Services Team w: djrgarcia.com
- 19. w: djrgarcia.com Legal Counsel w: djrgarcia.com Most startups refuse to justify this spend thinking they can do it themselves, but would you perform your own medical procedure instead of using a doctor? Work with legal counsel early on to avoid catastrophic mistakes or issuing securities in violation of federal and state law Negotiate flat-rate or project-based legal engagements to make your legal spend more predictable for your budget
- 20. w: djrgarcia.com Accountants/CPAs w: djrgarcia.com Accounting experts are a must-have on your team, whether internal or external. 409A valuation will be a major component of Seed or Series A financing. Remember that the company (if it’s a C-corporation) will have its own tax reporting obligations separate and apart from the founders’ tax liability/considerations. Understanding an 83(b) election for founders receiving restricted stock is a key consideration.
- 21. w: djrgarcia.com Other professionals w: djrgarcia.com Is your company working in a highly-regulated space? If so, specific consultants may be needed to ensure compliance. • Examples: healthtech; medtech; fintech; cannatech; government contracting; etc. Don’t look at your professional team as a “cost item” to be minimized at every turn; instead, consider them as partners that help to mitigate risk and present a professional quality to your startup to attract the best investors.