There are four common equity financing options for a start-up corporation: common stock, preferred stock, convertible notes, and SAFEs. Note that this entry focuses on financing options for corporations. Use of the LLC entity type for some of these may create complications, including potential tax consequences for the equity owners.
• Common Stock
• Convertible Note
• Preferred Stock (usually convertible)
• Simple Agreements for Future Equity, or SAFE
COMMON STOCK is perhaps the purest ownership interest in a business entity. Generally speaking, common stock comprises the voting shares of a company and also signifies the ownership interest that a typical founder of a company would have. At its base, a common stock owner owns the fraction of the company represented by the number of shares the owner owns divided by the total number of shares outstanding.
And because common stock generally does not have any special rights associated with it, so long as the company (if corporation) has issued enough shares, there is no need to amend such corporation’s charter (other common names for a charter are certificate of incorporation, articles of incorporation, etc.).
For an investor, however, common stock (especially of a startup, which generally is thought of as riskier than a mature company) may not be sufficient. Common stock necessarily lacks certain privileges, protections, and rights that an investor may want. Chief among them may be the protection against the risk of dilution. Because startups tend to need to lure talent by promising certain equity stakes in the company, usually through stock options or restricted stock, an investor risks future dilution of his or her shares without any protective language in place.
PREFERRED STOCK, which is a catch-all term for shares that have a preferred position over the common stock in liquidation, generally combines some debt-like qualities along with equity. A preferred stock could have other rights, limited only by imagination and some practical concerns.
A typical “funding round” in a startup (Series A, Series B, etc.) company is done through preferred stock. It typically includes certain dilution protections, right to convert into common shares, certain annual return on investment (or internal growth of the value of the convertible shares instead of cash payment), preferred position in liquidation, and sometimes liquidation multiples. Sometimes preferred stock may vote along with the common stock. Preferred stock is well-understood by investors.
But since there are many different aspects that need to be negotiated, the time and cost of effectuating such investment could be long and high. Most likely, the company would also have to amend its charter to reflect certain rights specific to the preferred stock.
A CONVERTIBLE NOTE, or really, any convertible debt, is perhaps the most popular way that I see for early stage investors to invest into a startup. A convertible note is basically a simple debt that, either upon a certain triggering event or at the lender’s choice, converts into common stock at a previously agreed upon price.
Because the investment acts as debt prior to conversion, it is quite simple. There is generally no need to amend the charter or to involve other legal heavy-lifting that perhaps a preferred stock might need. Sometimes, parties even agree to the type of equity into which the debt would convert, but would hold off on creating the new class of equity until conversion happens.
At the same time, because it is debt, the company will likely need to service the debt. And even if the investor is willing to forego periodic interest payments the convertible debt generates, the convertible note eventually mature. When the debt matures, the investor could demand payment on the note in cash, which could potentially cripple the operation of the company or, worse yet, threaten the existence of the nascent company.
Sometimes, convertible notes can also contain complicated privileges, protections, or rights for the investor.
A SAFE is probably the simplest way in which an investor could invest into a company. There is no maturity date. Generally, there is also no interest accrual. The lack of features also means likely an investment through a SAFE favors the company.
A SAFE, however, is also likely the least common method of investment, and therefore an investor may be unfamiliar with it. And that unfamiliarity could mean more uncertainty for investors. And unfortunately, an uncertain investor is an investor who is less likely to pull the trigger. Stated differently, it may be more difficult for a company to find an investor who is willing to invest into the company via a SAFE.