You’ve probably heard of Convertible Notes, SAFEs, and KISS agreements as common ways to raise funds during early-stage rounds. But which one is best for your startup?
In this article, we’ll break down what each of these fundraising is, how they work, and the pros and cons of each, so you can make an informed decision that aligns with your goals as a founder.
What You Need to Know About Startup Equity
Before into the specifics of Convertible Notes, SAFEs, and KISS, it’s essential to understand how startup equity works. Your company’s equity is represented by shares of stock. When you raise funds, new shares are issued rather than transferring existing shares from the founders.
For example, if two founders each own 50% of a company with 10,000,000 shares, they each own 5,000,000 shares. When an investor comes in, the company issues new shares based on the valuation agreed upon. This ensures that the existing shareholders don’t lose any of their original shares, but the overall number of shares increases.
The valuation of the company plays a key role in determining how many shares the investor will get, which is why raising money can be tricky, especially in the early stages. And that’s where Convertible Notes, SAFEs, and KISS agreements come in — they allow you to raise money without agreeing on a valuation upfront.
1. Convertible Notes: The Traditional Option
Convertible Notes are one of the oldest methods of raising capital, having been in use for over a century. The idea behind them is simple: an investor loans money to a startup with the understanding that the loan will convert into equity at a later fundraising round.
How Convertible Notes Work:
- Loan structure: This is technically a loan, but instead of being repaid with interest, it will be converted into shares of the company at a future financing round.
- Interest rates: Convertible notes typically have an interest rate (usually between 2% and 7% per year).
- Maturity date: Convertible notes also have a maturity date, meaning the loan will convert into equity or be repaid after a certain period (typically 18-24 months).
- Valuation cap and discount: To protect early investors, convertible notes often include a valuation cap or a discount rate. These ensure that investors are rewarded for taking on early-stage risk.
Example: Let’s say an investor loans $1M to your startup. The investor’s loan will convert into equity at the valuation set by a future investor or at a discount, depending on what’s better for them.
Pros:
- Delayed valuation: Founders don’t need to agree on a valuation right away.
- Investor protection: The valuation cap and discount ensure early investors benefit from their risk.
Cons:
- Complexity: Convertible notes have many moving parts, including interest, maturity dates, and caps, making them harder to negotiate.
- Risk of dilution: If a large round of funding happens at a high valuation, early investors could receive much less equity than they anticipated.
2. SAFEs: The Simpler Alternative
SAFEs (Simple Agreements for Future Equity) were introduced by Y Combinator in 2013 as a simpler, more standardized alternative to Convertible Notes. SAFEs are similar in that they allow investors to inject capital without agreeing to a valuation upfront, but they don’t involve debt or interest rates.
How SAFEs Work:
- No debt: Unlike Convertible Notes, SAFEs are not loans and do not have interest rates or maturity dates.
- Valuation cap or discount: SAFEs also use a valuation cap or a discount (just one of the two), meaning investors will convert their SAFE into equity at a lower valuation than future investors if the company does well.
- Simplified documentation: SAFEs are typically just 5 pages long and are much simpler than Convertible Notes, with little legal complexity.
Example: An investor agrees to invest $1M via a SAFE with a valuation cap of $10M. When a new investor comes in at a $20M valuation, the SAFE investor will convert their $1M investment at the $10M valuation, securing more equity for their early risk.
Pros:
- Simplicity: SAFEs are much easier to understand and use compared to Convertible Notes.
- Lower legal costs: They are standardized agreements, that reduce legal fees.
- Faster fundraising: SAFEs allow founders to quickly move from fundraising back to building their business.
Cons:
- Less investor protection: Without a maturity date, some investors may feel uncertain about when (or if) they’ll convert their SAFE into equity.
- Newer and less familiar: Some investors, especially those outside the US, may not be familiar with SAFEs.
3. KISS: A Hybrid Option
KISS (Keep It Simple Security) agreements were introduced by 500 Startups as another alternative to SAFEs and Convertible Notes. KISS agreements combine some aspects of Convertible Notes and SAFEs, offering both simplicity and some investor protections.
How KISS Works:
- Debt-like features: KISS agreements can be structured as either a debt or equity agreement, giving investors flexibility.
- Valuation cap and discount: Like SAFEs, KISS agreements usually include a valuation cap or discount to ensure early investors aren’t penalized.
- Maturity date option: Depending on the agreement, KISS may or may not include a maturity date.
Pros:
- Flexibility: KISS agreements offer a balance between the simplicity of SAFEs and the protections of Convertible Notes.
- Investor familiarity: Some investors may be more comfortable with KISS agreements than SAFEs because they resemble Convertible Notes more closely.
Cons:
- More complexity than SAFEs: While simpler than Convertible Notes, KISS still involves more complexity than SAFEs, particularly with the option for maturity dates and debt structure.
Conclusion: Which Option Is Best for Your Startup?
Choosing the right funding vehicle depends on your startup’s needs and the preferences of both you and your investors. Here’s a quick rundown of which option might be best for you:
- Convertible Notes: Best for startups looking for a traditional, investor-friendly option with protections like valuation caps and interest rates.
- SAFEs: Ideal for founders seeking simplicity and lower legal fees, especially if you want to move quickly and don’t need debt structures.
- KISS: A good middle ground for founders who need a bit more flexibility and are okay with a more complex agreement than SAFEs.
No matter which option you choose, the key is to understand how each one will affect your company’s equity and control in the long run. As a founder, it’s crucial to balance attracting the right investors with ensuring the terms align with your growth vision.
