Note the editor: This is a part of the two-part series about two financial instruments, which Angel investors use to invest more easily in the startup of the initial stage. While this article is about the chests, Part will cover two convertible notes.
In 2024, the size of the Global Angel Investment Market was around $ 28 billion. It is estimated to increase by $ 72.35 billion by 2033. While such investment in startups can be highly profitable, they also take important risks. If an investor is ready to take that risk, the next question is how to make the deal properly.
Accredited investors can use both direct startup investment and syndicate deals. You do not need to be an American resident to use the popular angelist platform – providing evidence of your recognized investor’s status.
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The most effective way to protect his interests for an angel investor is to get shares in direct startups.
However, with the initial stage startup, this approach is uncommon due to challenges in determining high legal costs and proper assessment. Instead, to finance such startups, the enterprise capital industry depends on simple financial instruments.
My portfolio includes 52 startups in various courts. Most of them are supported by chests, and sometimes I use convertible notes. I want to explain what these agreements include and what factors to consider to improve your chances of increasing investments, very minimum, to resume your investments.
Spoiler Alert: None of these compromises ensures that you will get your money back.
What is a safe?
A safe (simple compromise for future equity) is a brief six to seven-seven-seven-pavement agreement between a founder and an investor. This works in this way: Investor now provides a capital (purchase amount) to the startup and receives the company’s shares in the future.
A safe phenomenon is converted into a safe stocks, called equity financeing. This is a fundamental era where new investors are released standard preferred stock. In contrast, the founder and the team have a common stock.
A safe advantage startup in the following ways:
- It is not classified as a loan, so it does not appear as an obligation
- There is no predetermined date for conversion to shares
- This investor does not give shareholder rights
Despite the risks, investors choose a safe as it is the easiest and fastest tool to invest in early stages. The market is standard post-money safe, which uses the valuation cap after equity financeing rounds (ie, including money received from investors). I will focus on this version of safe below.
Important conditions of a safe
- Valuation cap. This is the upper range of evaluation at which the funds of the investor will turn into shares. If the actual assessment is more than this cap, the initial investor will get several shares based on the valuation cap. In other words, they will acquire shares at a lower price than the price paid by investors in the equity financeing rounds.
- discount rate. Simply put, this is a decrease in share price prescribed during equity financing. Depending on my experience, the discount usually does not exceed 20%, which means the discount rate is 80%. If series A investors buy shares for $ 1, the safe holder will acquire them for 80 cents.
Series A is the first major phase of funding for startups after the initial seed capital. Startups on the seed stage usually use funds to validate their core hypothesis and identify a product that users are actually ready to pay.
The seed phase is often referred to as the “Angel Stage”, as business angels usually have primary backs of startups during their early stages of growth. Series A funding is raised to score a successful business model.
Types of chests
The Y Combinator Accelerator, who made it safe, provides three variants:
- Valuation cap, no discount. This option includes a valuation cap, but does not provide discounts for the investor. For example, if the purchase amount is $ 100,000, the valuation cap is $ 5 million, and the company’s evaluation during equity financing is $ 10 million, the safe holder will receive: $ 100,000 / $ 5 million * 100 = 2% shares. In comparison, series A investors will receive 1% shares for the same $ 100,000.
- Discount, no evaluation cap. This option provides discounts to investors. With an evaluation of $ 10 million and 80% discount rate, an investor will receive: $ 100,000 / ($ 10 million * 0.8) * 100 = 1.25% shares. Investors will get 1% shares for the same amount without discount.
- MFN, no valuation cap, no discount. This option includes an MFN clause, which I will explain below, and do not specify a valuation cap or discount.
A fourth version of safe was widely used in practice in delaware. Although it has been removed from the Y Combinator, it continues to be used and connects both a valuation cap and discount.
In this case, the investor can choose a more profitable way to convert your investment into shares by using the valuation cap or applying the discount rate.
For example, if the valuation cap is $ 5 million, the discount rate is 80%, and equity finance round valuation is $ 10 million, it is more beneficial for the investor to convert on the basis of the valuation cap: they will get 2% instead of 1.25% shares (see the above mentioned examples).
However, if the evaluation of startups during equity financing is equal or slightly higher than the valuation cap, the landscape changes.
For example, with a company assessment of $ 5 million valuations cap, 80% discount rate, and $ 6 million in equity financing, the investor will benefit more than the discount rate. They will get $ 100,000 / ($ 6 million * 0.8) * 100 = 2.08% shares compared to 2% with valuations cap.
I presented a simplified calculation to portray the underlying principles. In practice, the number of shares during safe conversion is determined using the formulas specified in the agreement and takes into account various conditions.
What type of safe is more beneficial for investor?
During the deal negotiations, there is no way to know which conversion method – valuation cap or discount rate – will eventually prove to be more beneficial for the investor. The most favorable option for the investor is a safe which includes both valuations cap and discount.
However, these words are not ideal for startups, and founders usually do not agree with them.
Just allows a safe investor to understand the potential advantage with just a valuation cap that they are putting at risk. I believe that a discount-on-one option without valuation cap is unfair to beginner investors. They only get a discount of 20%, while their risks are not 20% less, but are much higher than later investors.
The MFN (most preferred nation) section enables investors to achieve the same conditions as future investors that make a newly safer sign with startups. This type of agreement includes only the procurement amount.
The safe holder wait for another investor to protect the adaptable terms with the startup and then align with them. I have not joined such deals.
I use a safe that always includes a valuation cap and advises all the novice business angels to do the same. It is appropriate to accept only one discount when you are working with a promising startup that is not open to other conditions.
However, the enterprise funnel is structured in such a way that such startups usually do not reach inexperienced investors.
How is an investor safely preserved?
A safe company does not provide the same protection as placing shares. However, it includes other protective mechanisms, such as:
- Liquidity phenomenon. This usually refers to the sales of the company before equity financing on a lower evaluation than the valuation cap. In such cases, the investor can choose the most favorable option – either to get back their purchase amount or to convert their investment into a common stock and sell it.
- Disintegration incident. It is related to bankruptcy. If the company is dissolved, the investor is entitled to the part of proportional remaining money for his investment. However, if the startup does not have any funds left, then the investor will not get anything.
A negative side liquidation is a priority clause, which specifies that in the event of the company’s sale or closure, the investor receives his payment after the creditors and holders of convertible notes.
In other words, there may be no enough money left for the investor, which is a common phenomenon in the enterprise world.
A side letter in a safe
A side letter is an agreement where parties underline additional conditions. Although this is not an essential document, I strongly recommend interacting on its inclusion. Here are some provisions that can be found in a side letter:
- Pro Rata Rights. This gives investors the option to maintain their ownership percentage in startups. For example, if the share of an early investor falls from 10% to 5% after the equity finance round, they have the right to buy more shares to bring back their ownership to 10%. The shares should be purchased at the same price that was acquired by new investors, without any discounts for safe holders.
- Right to Information. This section ensures that early investors are informed about the progress of startups, usually through quarterly and annual financial reports. Standard conditions of safe do not tell startups to report to initial investors, and as a result, they are often left in the dark.
My second article in this series will cover how to use convertible notes to invest in startups, including some comparisons, some comparisons.
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This article presents the ideas of our contributing advisor, not by Kiplinger editorial staff. You can check advisory records with Second Or with Finara,
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