Venture Capital Funding Agreements
If you're seeking funding from a venture capitalist (VC) for your startup, there are several structures they might use to invest. Each comes with its own terms and conditions that can impact your ownership, control, and financial future. If you’re super early, a traditional priced round may be out of reach. Depending on your goals it may make sense to raise an “unpriced round.” What does all of that mena? Let’s discuss the most common options!
To begin, what’s the difference between a "priced round" and an “unpriced round.” A priced round means a startup and investors agree on what the company is worth (its valuation). You now know the “price” of your shares. That means if I give you $10 and your company is worth $100, I now have 10% of your company.
An “unpriced round” means that there is no valuation yet. You don’t yet know the price of your shares, but raise money from bold investors on an IOU with strict added benefits.
We’re focusing on priced rounds, Safe notes and convertible notes. Remember the $10=10% of $100 valuation part we’ll be using it to explain a LOT.
Safe Notes
How It Works: Investors give you money now in exchange for the right to receive equity in a future priced round. It’s an equity IOU.
Example: You want to make a pizza. A friend gives you $10 now for the pizza. You don’t know how much your pizza will be worth yet. Later on when the pizza is done you decide it’s worth $100 (work with us here). If another friend gives you $10 now they’ll have 10% of your pizza, but the first friend believed in you before you even had a pizza so their $10 may be worth 12% of the pizza.
Note: Y Combinator introduced the safe (simple agreement for future equity) in late 2013. Their site has a lot of information, including the difference between a pre-money safe and a post-money safe, if you’re ready to dive in and learn more.
Convertible Note:
How It Works: Similar to a SAFE, but it is structured as a loan that converts into equity later.
A loan from a bank, but instead of paying back in cash, you pay back with shares.
Investors give you money now, like a loan.
It has interest (meaning you owe a little extra over time).
It has a deadline—if you don’t raise more money by then, you might have to pay them back in cash instead of shares.
Back to our pizza example. Your friend gave you $10, but charges 10% interest every year. After 1 year, that’s $11 that will have to be converted to equity. Not to mention their discount.
A convertible note is a good option only if you will know the price (have a priced round) relatively soon. Otherwise, you’ll have to give the money back +interest or the interest will accrue and you’ll lose way more equity than you planned for.
SAFE notes are simpler overall for both investors and founders, but Convertible Notes offer a bit more protection for investors since they’re treated as debt. This can entice investors for startups that are a bit riskier.
Priced Round
How it Works: Once a startup is ready for a more traditional VC investment, they usually raise a Series Seed, A, B, etc. as a priced round in exchange for preferred stock
You made a pizza. The pizza is worth $100. Your friend gives you $10 for 10% of your pizza.
Some terms to know:
Preferred Shares: Investors get preferred stock, which has advantages over common stock.
Valuation & Dilution: Startup and investor agree on a valuation that sets the per-share price. Dilution occurs in subsequent rounds when more investors join the Cap Table
Cap Table: a spreadsheet that shows a company's ownership structure
Pro Rata Rights: Investors get the right to maintain their ownership percentage in future rounds by investing more.
Liquidation Preference: Investors get paid first in an exit, often at 1x-2x multiple of their investment before common shareholders.
Board Seats & Control: Investors may require a board seat or veto rights on key decisions.
