What is the Choice of Financial Instruments for Startups
Startups, like other established businesses, have one thing in common – they need cash to operate. For established businesses, when successful, banks are often a good source of funding. However, this doesn’t work out for startups. They do not have a banking history and therefore need funding from investors. But how can they attract investors, and what benefits do investors gain?
Startups can use a variety of financial instruments to attract investors, with the choice often depending on the company’s maturity, growth rate, and cash flow. Early-stage startups usually favor flexible, quick, and non-dilutive or low-dilution instruments, while later-stage companies often move toward equity-heavy rounds.
Early-Stage & Pre-Seed Instruments (Speed and Flexibility)
- SAFE (Simple Agreement for Future Equity): Originally introduced by Y Combinator in California in 2013, SAFEs are now common and used globally. A SAFE agreement is a contract that gives an investor the right to purchase stock at a discounted price in a future equity round. A SAFE is not debt, accrues no interest, and has no maturity date, making it highly founder-friendly.
- Convertible Loan Notes: A form of short-term debt that converts into equity at a later date, usually during a priced round. They include a maturity date (18-36 months) and an interest rate, allowing them to convert earlier if needed, often with valuation caps or discounts to reward early risk-taking.
- KISS (Keep It Simple Security): Similar to SAFE notes, but often includes features that make them behave more like debt, providing more structure while still deferring valuation.
Growth & Seed-Stage Instruments (Priced Funding)
- Preferred Equity: Investors receive shares that offer specific rights, privileges, and preferences over common stock, such as liquidation preferences, ensuring they get paid first during an exit.
- Convertible Preferred Stock: Preferred shares that can be converted into common stock at the option of the holder, usually during an IPO or acquisition.
- Bridge Rounds: Extra money raised between priced rounds to extend runway, often using SAFEs or notes to quickly bridge the gap.
Non-Dilutive & Alternative Financing (Retain Ownership)
- Revenue-Based Financing (RBF): Startups receive capital in exchange for a percentage of future monthly revenue. It is ideal for SaaS or e-commerce companies with predictable cash flow, as repayments scale up or down with performance.
- Venture Debt: A loan for companies that have already raised equity-backed funding, used to extend runway without immediate dilution. Lenders often take warrants (stock options) to boost their returns.
- Grants and Subsidies: Funds provided by governments or foundations that do not require repayment or equity, usually for R&D or innovation. You may need weeks and months to comply with all regulations, and also lose flexibility.
- Equity Crowdfunding: There are multiple online platforms that allow startups to raise capital from a broad audience, transforming users into investors. The price tag is high, ranging from 7% to 10% if the founding round is successful.
Key Terms in Financing Instruments
- Valuation Cap: The maximum valuation at which an investor’s SAFE or convertible note converts into equity, protecting them from excessive dilution if the company value skyrockets.
- Discount Rate: A percentage discount (often between 15% – 20%) applied to the price per share of the future priced round, rewarding early investors.
- Warrants: Rights given to lenders (often in venture debt) to purchase shares at a predetermined price.
TAXEDO Legal has extensive experience with all types of financial instruments. You may find out more about Convertible Loan Notes here. Please contact us via WhatsApp or Telegram to discuss your funding needs.