Debt Financing and Conversion Mechanics with Hilary St. Jean
If you’re a founder in need of quick funding but aren’t sure how to raise in between larger equity rounds, debt financing may be the route for you. Hilary St. Jean, Partner at Rogoway Law Group, is a seasoned expert in financing transactions and joined me at the Angel Club to share the different avenues of financing, and how to define conversion mechanics in your term sheet to achieve your financing goals.
SAFEs vs Promissory Notes
One of the most common forms of debt financing is through promissory notes. Promissory notes are a simple and straightforward way to document the terms of an agreement and can be secured or unsecured in both short-term and long-term loans. Although lenders are repaid with interest, promissory notes allow startups to raise capital without giving up ownership stakes and often have lower interest rates than other forms of debt financing.
SAFEs, on the other hand, are a form of equity financing where investors provide funding in exchange for the right to purchase equity in the startup at a later date. “SAFEs are very company friendly because they aren’t debt,” Hilary says. However, “...they can be challenging for investors.” While beneficial for founders, one of the biggest drawbacks with SAFEs for investors is that they don’t have a maturity date, which means that their money is tied up indefinitely.
From a cost perspective, Hilary says, “They're both pretty cost-efficient…typically, you can have standalone notes and standalone SAFEs and do a pretty significant round. At the end of the day, both are much better than doing a price round at the early stage.”
When it comes to structuring your startup investment, there’s no one-size-fits-all solution. If you're looking for a simple and founder-friendly investment option, SAFEs may be the way to go. However, if you're looking for a more predictable return and greater investor protection, promissory notes may be a better fit. As always, it's important to consult with a legal and financial professional, like Hilary, before making any investment decisions.
Conversion mechanics determine how debt is converted into equity, and can have a significant impact on the ownership structure of the company. If the conversion price is set too low, early investors can end up with a much larger stake in the company than they would have if the price was set higher, which can cause problems down the road if the company needs to raise more funds and dilutes the ownership of existing shareholders.
“The conversion mechanics in your term sheet are extremely important,” Hilary says. One of the biggest pieces of advice she gives is to “define your conversion event carefully and set realistic goals ahead of the maturity date.”
Oftentimes, investors prefer to have a valuation cap, and the lead investor will set the terms. It’s extremely hard to come up with a valuation at an early stage, and as a founder, Hilary says to think of the valuation cap as a ceiling, rather than the current valuation.
“You don't know exactly what the valuation cap is going to look like because you don't know what your future round is going to be,” Hilary says. To help set benchmarks, talk to other founders who have a similar business model to see what they have raised in pre-seed or even Series A.
However, before you have a transaction or agree to any terms, you should be modeling it out. “When you have complex analytics, it's nice to have your cap table to build on every time you have a transaction.” While there are resources out there, like Carta, to help you model your cap table, Hilary strongly recommends seeking the guidance of a legal professional to help guide you and build your roadmap.
Preferred Stock Financing
Preferred stock financing comes with “significant documentation and significant rights for preferred investors,” Hilary says. Shareholders are entitled to receive a fixed dividend payment before any dividends are paid to common stockholders. This means that preferred shareholders receive a guaranteed return on their investment, regardless of the company's financial performance.
Additionally, preferred financings are extensive negotiations, and are much more time-consuming upfront. “You would typically only do a preferred round when you're bringing in some significant money because you're giving away some significant rights and governance,” Hilary says.
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