Lesson 3: Determining your Raise

Determining What Type of Raise is “Best” Suited for Your Company

So how do you choose what type of raise is best for your company? Decide on the different types of contracts and set the terms?

Your investment contract is the most important part of your raise. If you choose the wrong contract or have the “bad” terms, no one will invest, and you will have wasted a lot of time. It’s like trying to sell a gallon of milk for $1,000. While you may be able to sell one person on $1,000 of milk, you can’t build a business on it.

The right terms are specific to your company, but here’s general advice to help you decide.

First, you need to decide between debt and equity — where the biggest difference is the risk and reward. Debt is slightly less risky for investors, but there is also much less upside. Equity is riskier, but potentially much more lucrative.

• Debt. Investors lend the company money today for more money tomorrow. Investors are not shareholders, although they have a right to company assets if the company goes under. There are different variations of debt contracts but the two we mainly focus on are: Simple Loans and Revenue Share.

• Simple Loans – these are the loans you’d most likely recognize. Car loans, home loans, student loans, personal loans, etc. are all simple loans to a certain extent. Sometimes they can be secured with collateral like a car loan. These instruments offer capital to the borrower immediately and the borrower makes regular payments with interest until the loan is paid off.

• Revenue Share – Revenue share is a debt instrument where the borrower agrees to pay a % of gross revenue to debtholders, sometimes after a grace period, up until the debtholders are compensated to a specific return multiple. A 1.5X multiple would mean that the debtholder would get what they put in plus 50%. Revenue share is simple but with many variants that make it seem complex. Since it is pegged to gross revenue there is a chance for debtholders to be paid back faster, but since the return is fixed a faster payoff means a better ROI over time.

• Equity. Investors buy shares or units in the company for ownership. Investors earn a return if the company is acquired, goes public on the stock market, or pays dividends. There are different variations of equity contracts but the two we mainly focus on are: Common Stock, Convertible Notes, and SAFE Notes.

For an early-stage technology start-up that has a reasonable chance of getting funded by venture capitalists, what is commonly used is a Convertible Note or a SAFE Note. Valuation caps for early-stage technology start-ups with no prior investors can range from $2 million to $5 million. It’s possible for the best early-stage start-up (such as a Y Combinator start-up) to raise at closer to a $10 million valuation cap. However, if that’s the case, then you will have at least one prior professional investor who sets the terms. Common Stock is generally used when a company has a more established operating history under its belt and there is enough information available to establish a fair price.

For an early-stage brick and mortar with expected cash flow, what is commonly used is a Revenue Share contract. We recommend offering at least a 2X return. Make a spreadsheet of all your projected cash flows for the coming six years. Choose the percent of revenue to share that would predict a 10%+ annual return for it to be worth it for the investor.

When are Revenue Share agreements generally used?

A revenue share is generally used by early-stage brick and mortar businesses already making cash. It is a promissory note that is paid back from a share of the revenues of the business. It’s typically more exciting for investors than a standard loan based on how it’s structured. Since the payments vary based on revenues, it can also be safer for a company with less predictable cash flows.

How does a Convertible Note work?

One of the most common methods used to invest in early-stage start-ups is called a Convertible Note. A convertible note is a loan that converts into equity after the company has more operating history under its belt and there is more information available to establish a fair price.

When someone invests through a convertible note, the start-up receives the money right away, but the number of shares the investor is entitled to is determined during its next round of financing, typically a Series A round. At that point, the company will have some operating history that more experienced angel investors or venture capitalists can review to determine a fair price. Once the series A investors have determined a price, the loan converts into shares at a discount to the Series A price to reward the investor for the additional risk they took on by investing early.

The amount of equity that a note converts into depends on the price of the A round, plus two key components of your note.

• Valuation Cap. The Valuation Cap is the most important term. It entitles investors to equity priced at the lower of the valuation cap or the pre-money valuation in the subsequent financing. Typical Valuation Caps for early stage, but post- “friends and family”, start-ups range from $4 million to $20 million.

• Discount Rate. The default is 0%. This term is rarely used and not recommended unless a major investor asks for it. It gives investors a discount on the price of stock when the pre-money valuation is less than your valuation cap. Typical discounts range from 0% to 10%.

Which start-ups usually tend to use a SAFE Note?

A SAFE Note can be used by a technology start-up raising under Regulation Crowdfunding, which intends to raise venture capital, eventually.

Inspired by the Y Combinator Agreements, a SAFE Note (Simple Agreement for Future Equity) grants an investor the right to purchase equity at a future date.

Unlike a convertible note, a SAFE is not a loan. It does not accrue interest or have a maturity date. This makes things simpler and negates much of the need to amend the agreement. For example, it helps start-ups not waste time extending maturity dates or revising interest rates, if a Series A financing takes longer than you first expect. It also better aligns with the intention of most equity investors, who never intended to be lenders.

Some things to think about regarding SAFE Notes:

• Repurchase Rights. The company may opt to repurchase an investor’s SAFE note prior to conversion at Fair Market Value. Fair Market Value is determined by an appraiser the company chooses.

• Potential to be Amended by One Lead Investor. The lack of a maturity date and interest rate negates the need for common amendments of convertible note financing. However, if an extraordinary situation requires an amendment, you will not be required to chase down hundreds of signatures. The company designates a Lead Investor Representative, and all investors agree to allow that person to amend the SAFE unilaterally.

• CEO Power of Attorney Grants for Minor Shareholders. Once the SAFE converts into equity, investors who are not Major Shareholders grant the then-current CEO a power of attorney to vote all shares and execute any documents on their behalf. This mitigates the potential problem of hundreds of minor shareholders slowing down follow-on financing.

• Investment Limit Confirmation from Investors. All investors show if they are accredited or unaccredited. They represent that they follow the investment limitations of Regulation Crowdfunding.

Here is a list of the types of raises we work with; you can find more details on each in this week’s bonus modules:

Side by Side – Regulation D & CF

$500K – $3 Million Raise

4 Weeks to Launch Campaign

3-4 Months to Raise Capital

100,000+ Investors

VCs and Family Offices

Accredited Investors

Non-Accredited Investors

Raise from Users & Customers

Accredited Only – Regulation D

$500K – $3 Million Raise

4 Weeks to Launch Campaign

3-6 Months to Raise Capital

10,000+ Investors

VCs and Family Offices

Accredited Investors Only

Mini-IPO – Regulation A+

$3 Million – $25 Million Raise

3 Months to Launch Campaign

3-9 Months to Raise Capital

100,000+ Investors

VCs and Family Offices

Accredited Investors

Non-Accredited Investors

Raise from Users & Customers