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Investment Contracts

  • What is a SAFE?

    First developed by Y Combinator in 2013, a SAFE grants an investor the right to obtain equity at a future date if the startup sells shares in a future financing. It has been historically used by top startups in Silicon Valley raising money from accredited angel investors. You should only invest in a SAFE if you believe that the startup can raise financing in the future from professional investors.

    SAFEs are used by early-stage startups because they delay the difficult task of figuring out how much a startup is worth. It is also a much cheaper and simpler contract than priced equity rounds, which may require months of negotiation and upwards of 30 pages of legalese costing tens of thousands of dollars.

    The number of shares you receive is determined at the next priced financing when professional investors – typically venture capitalists – set the price for preferred stock. Then, calculated by using the Valuation Cap and sometimes the Discount Rate, your SAFE often converts into shares at a lower price than the venture capitalists paid, since you invested earlier.

    The Valuation Cap is the most important term in this security. It puts a maximum price on the price of the stock - the lower the price, the more shares you will get. If you invest in a startup with a valuation cap of $8 million, and they later raise at a $20 million Pre-Money Valuation, the amount of stock you'll get will be priced off the $8 million number. But, if the next investors value the company at $4 million, that will be your price instead (perhaps further discounted by the Discount Rate).

    Unlike a Convertible Note, a SAFE is not a loan. As such, it does not accrue interest, have a maturity date, or have a legal obligation to be paid back. This makes it a simpler and cheaper way to finance a startup, and it typically better aligns with the intention of most early stage equity investors who never intended to be lenders (convertible notes are rarely if ever paid back in cash despite being a debt instrument – the startup just goes bankrupt).

    Carolynn Levy of Y Combinator authored the SAFE.  You can watch her video explaining it:

    Further Reading:

  • What is a Convertible Note?

    A convertible note is an unsecured loan that converts to stock at some point in the future. They are one the most popular forms of seed-stage startup investing because of their history, although the SAFE is rapidly becoming more prevalent.

    Convertible notes are also useful because they delay the difficult task of figuring out how much the startup is worth. The number of shares you receive is determined at the next qualified financing (typically $1 million), when venture capitalists set the price for preferred stock. Then, calculated by using the Valuation Cap, Discount Rate, and Interest Rate, your loan converts into shares at a lower price than the venture capitalists paid, since you invested earlier.

    If the startup does not raise another round of funding, the note becomes due at the maturity date, typically in 18-24 months. Convertible notes, however, are rarely repaid in cash. Instead, the note usually converts to equity at a pre-set target price.

    The discount and interest rates have a relatively minor impact on future returns. The most important term to focus on – which can greatly impact the price of your future shares – is the Valuation Cap. This is usually set between $3 to $20 million, depending on how "hot" the startup is.

    Learn more about convertible notes.

  • How does Preferred Stock work?

    Only a few years ago, legal fees cost upwards of $50,000 to properly set up a stock financing. It was uneconomical to pay this amount unless venture capitalists were investing millions in a Series A. Nowadays, some startups can use open-sourced "priced round" documents to reduce the costs of a stock financing at the seed stage.

    There are a host of terms that can be negotiated in a stock financing, but this is done by the "lead" investor, who typically invests upwards of $200,000.

    As a non-lead investor investing a small amount, the most important terms to pay attention to are the Post-Money Valuation or the Pre-Money Valuation. This is effectively what the company is considered to be worth, and with it, you can calculate your percentage ownership. Comparatively, the price of the stock is relatively meaningless.

    One of the most popular open-sourced priced round agreements is the Series Seed, developed by Fenwick lawyer Ted Wang.

    Read more about Series Seed.
    Learn more about terms

  • How do revenue share or loans work?

    High-growth startups almost never raise seed-stage funding with loans, as debt doesn't offer enough of a return to account for the risk investors are taking.

    However, loans or promissory notes can be more appropriate for small businesses that are cash-generating. One benefit of investing with a loan is that the investor often receives cash every quarter or year, as the principal is repaid alongside the interest rate. The downside of debt is you have no equity stake if the company suddenly becomes much more valuable.

    A Wefunder Revenue Share Loan Agreement is a promissory note that is paid back from a share of the revenues of the business.  

    Important terms in this note include:

    • Gross or Net Revenues. Net revenues exclude returns or shipping costs.
    • Revenue Percentage. This is the percentage of revenue that is shared.
    • Repayment Amount. Typically 1.5-3.0X, this is the maximum amount you will be paid back.
    • Quarterly or Annual Disbursement. Companies choose to make annual or quarterly payments.
    • Defer Payments. By default, every company can miss one payment without being in default.
    • Secured. Some loans may be secured with all property of the business.

    Some businesses choose not to share their revenue, and instead offer something more like a car loan, using the Wefunder Promissory Note.  Important terms in this note include:

    • Interest Rate. The interest rate per annum.
    • Maturity Date. How many years until the loan is fully paid back?
    • Quarterly or Annual Disbursement. Companies choose to make annual or quarterly payments.
    • Grace Period. By default, these loans are deferred until 30 days after their crowdfunding deadline date. Some businesses may defer the start of their loan at a later date, such as when their business is scheduled to open.
    • Defer Payments. By default, every company can miss one payment without being in default. This is meant to allow businesses time to recover if they have a bad year.
    • Secured. Some loans may be secured with all property of the business.
    • Personal Guarantee. Some loans may have an individual that personally guarantees payment.
    • Subordination. Some loans are subordinate to a major bank lender.