A capital raise is when companies approach investors to provide additional capital in the form of either debt or equity. It is common for startups to combine two or more sources of financing.
- Debt: Debt could be either conventional debt or convertible debt. For conventional debt, the startup borrows money from the investor with the obligation of future payment with interest. In some instances, the debt will be secured against an asset owned by the startup to serve as collateral in the event of default in repayment.
Convertible debt is similar to conventional debt—the startup borrows money from investors to repay later with interest. However, convertible debt goes further to give the investor or the startup the right to convert the debt into ordinary equity at a future date in lieu of repayment.
Banks can also be approached for loans, and the bank charges interest in exchange. However, many early-stage startups may not be able to obtain loans from banks because most early-stage startups do not have the track record of cash flow required by most banks.
An advantage of debt capital is that it does not require a company to give up a portion of its ownership to shareholders; hence, it keeps the founders from getting diluted. Further, the investor has no control over business operations. Debt capital, however, can be risky. This is because repayment and interest are not dependent on business performance. The debt and interest must be repaid in full at the agreed time, and in a low season, a startup may have debt payments that exceed its revenue.
- Direct Equity: This capital is generated through the sale of shares of company stock, which can be either common or preferred shares. Common shares give shareholders voting rights. For preferred shares, payment of a specified dividend is guaranteed before such payments are made on common shares, but preferred shareholders have limited ownership rights and no voting rights.
In raising equity capital, shareholder investment does not have to be repaid. The cost of equity capital is the number of returns (payment of dividends and stock valuation) on investment that shareholders expect based on business performance. However, the greater the number of shares sold, the greater the founders’ dilution. This is because each shareholder owns a piece of the business. This also implies that the potential cost may be higher than debt financing. The founders are giving investors rights to a percentage of the company’s profits in perpetuity, which could amount to a lot of money.
Equity financing can also be obtained through an initial public offering (IPO). This is a process that private companies undergo to offer shares of their business to the public in a new stock issuance, allowing a company to raise capital from public investors.
- SAFEs: SAFE is an acronym for ‘Simple Agreement for Future Equity.” A SAFE is an agreement between an investor and a startup (usually early-stage) in which the investor agrees to make a cash payment (investment) to the business. In return, the investor is granted the right to convert their investment into equity at a future price through funding or liquidation. The price per share is not determined at the time of the investment. It typically contains terms that describe discounts, valuation caps, pro-rata rights, valuation measurements, and non-discrimination clauses.
A SAFE could be Pre-money or Post-money. In a Pre-money SAFE, the investor doesn’t yet know what percentage of the company they own relative to the founders and other SAFE investors. Each investor only gets to know their ownership percentage after all SAFEs convert into shares during the subsequent pricing round. This is because the startup can’t give shares to the investor yet as the value of a share is based on the valuation of a company, and no valuation exists yet. Further, issuing a new SAFE dilutes the ownership percentage for the founder and all other SAFE holders.
The conversion price for each share is determined in part by the company’s capitalization, or the total value of the company’s equity. The company capitalization in a Pre-money SAFE is a pre-money valuation, meaning it does not include all the shares issued to all the SAFE holders.
To avoid the uncertainty of a pre-money SAFE, Y Combinator introduced the Post-money SAFE in 2018. In a Post-money SAFE, the company’s capitalization includes all the shares issued when all the SAFEs are converted. It, therefore, gives investors the ability to calculate precisely how much ownership of the company they purchase with their investment. Note that the new Series A investors may dilute this ownership stake, but the Post-money SAFE still gives investors a more defined idea of their ownership percentage.
Further, the Post-money SAFE puts the founders at a higher risk of getting diluted. This is because when all the SAFEs convert into shares at the first price round, none of them will mathematically affect each other; the percentages of the SAFE holders will remain fixed, no matter how many other SAFE holders are involved in the round.