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One of the most significant snags entrepreneurs face when starting a business with an innovative concept is the lack of funding. Investing their personal savings and borrowing small amounts from friends and family can only take them so far. Founders need an influx of capital to get their startups off the ground at the seed stage. Venture capitalists, angel investors, and incubators are the best sources for these fundraising initiatives.
However, these investors need some kind of assurance for their money, and safe notes are the key. Read ahead for detailed information on how safe notes work and how to use them to get ahead in your fundraising efforts.
What Is a Safe Note and How Does It Work in Fundraising Initiatives?
A safe note is a contract entrepreneurs and investors enter into for funding their seed-stage startup. The safe note concept was first developed in 2013 by Y Combinator, the Silicon Valley initiative that provides startups with accelerator programs. Safe notes are a version of conversion notes but ensure that founders maintain control over their companies.
Essentially, the safe note offers investors the opportunity to convert their loan into equity in the mature business down the line. At the same time, the contract includes several clauses that allow founders to work out the amount of equity they want to offer along with specific terms and conditions.
Safe Notes Are Good for Founders
Startups at the pre-revenue stages find it harder to acquire capital since they are unable to provide the typical metrics like profits, revenue, and sales, especially when they have yet to start production and sales. Safe notes provide an easy way out. Here are the advantages for founders:
- Investors providing the funding offer unsecured loans without any maturity date or payable interest.
- The loan remains outstanding as capitalized amounts in the company’s balance sheet for as long as it is not paid back in full or converted into equity.
- Founders can use the funds to build their new company with minimal interference from the investors. They need not reveal business secrets, offer board seats, or cede any voting or decision-making rights. This makes safe notes an ideal fundraising vehicle.
- Most importantly, entrepreneurs can sell safe notes to get funding while skipping the valuation process entirely. Most conventional investors will want to value the startup before offering money.
- Founders can take their time using the funds without worrying about accumulating debt and making interest payments, especially when there are no revenues.
- They need not push for the next fundraising rounds before they’re ready simply because it’s time to pay back the seed funding.
- Loans and funding a startup acquires through safe notes are not debt, per se. Further investment rounds won’t be a problem because of loans that appear as company debt.
Safe Notes Are Good for Investors
When investors sink money into startups’ fundraising efforts, their focus is on long-term gains. They are likely to vet the entrepreneur, the business idea, the operating model, and the products carefully before lending support. The backing they offer is for the long-term growth potential they see.
Since the new venture is not in a position to give interest payouts, investors defer returns. Instead, they understand they will be getting equity as the startup matures. Safe notes ensure these returns. Here are some of the added benefits for investors:
- Safe notes streamline the funding process and help with quicker negotiations. These contracts are typically simply worded, two-page documents without complex terms and conditions.
- Safe notes usually convert into preferred shares at discounted rates. As a result of the high valuation cap, investors stand to earn five to ten times the capital they initially invested in the new startup.
- Investors always have the option to enter into a “pro-rata” safe note agreement. Accordingly, they can invest more money into the startup to maintain the percentage of the equity they stand to own. Of course, they’ll pay higher prices for new safe notes to match upgraded values during equity fundraising rounds.
- The “pro-rata” right raises the value of the safe notes during equity funding rounds down the line.
Thus, safe notes are a win-win option by which founders can get the funding they need. On their part, investors can look forward to acquiring valuable equity in the company once it grows and is capable of making substantial profits.
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Choose the Right Kind of Safe Note for Your Fundraising Efforts
Founders can choose from four kinds of safe notes, depending on their fundraising needs and investor expectations:
- Safe notes that only have a valuation cap but no discounts.
- Those that have no cap but contain a discount when the note is converted.
- Safe notes that have both a valuation cap and discount.
- Safe notes that have no cap or discount. However, the funds remain in the company when these notes convert into equity.
Founders looking for funding for their new ventures can safely rely on these contracts to get the money they need. This applies particularly to terms and conditions that will permit them to run their company just as they envisioned.
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About the Author
Alejandro Cremades is a serial entrepreneur and the author of The Art of Startup Fundraising. With a foreword by Shark Tank star Barbara Corcoran and published by John Wiley & Sons, the book was named one of the best books for entrepreneurs. The book offers a step-by-step guide to today’s way of raising money for entrepreneurs.
Most recently, Alejandro built and exited CoFoundersLab, which is one of the largest communities of founders online. Prior to building CoFoundersLab, Alejandro worked as a lawyer at King & Spalding. There he was involved in one of the biggest investment arbitration cases in history, with $113 billion at stake.
Alejandro is an active speaker and has given guest lectures at the Wharton School of Business, Columbia Business School, and NYU Stern School of Business.
Alejandro has been involved with the JOBS Act since its inception and was invited to the White House and the US House of Representatives to provide his stands on the new regulatory changes concerning fundraising online.
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