Structuring the deal is a key step in completing a round of financing. While there are a number of ways an investment can be structured, deals you come across will commonly be one of three structures:
Convertible notes (also known as convertible debt), are a form of debt that convert to equity once a company raises a further round of financing. Rather than determining valuation at the time of the note, valuation is delayed until a later financing round
Convertible notes will either give investors a discount on further rounds, or place a cap on how high a valuation can go before investors are given equity based on that capped valuation.
Convertible notes are generally short documents that are easy to structure, which means that a round can be closed more quickly and with lower legal fees.
A SAFE (Simple Agreement for Future Equity) and other similar convertible equity instruments are another mechanism for startups to seek initial funding without setting a valuation.
SAFEs provide rights to the investor for future equity in the company without determining a specific price per share. The investor receives future shares when a priced round of investment or liquidation event occurs. For more on SAFEs, see Y Combinator’s description and example documents.
A priced round (or “equity stake”) occurs when the amount of equity an investor receives will be determined by a valuation that the investor and founder agree on together.
By setting a valuation for the company, investors know how much of a company they will own after their investment. For example, if the valuation for the round is $1M and you invest $10,000, you would receive 1% of the company.
Priced rounds are more popular in later rounds of financing (Series A+), require more time to complete, and generally incur higher legal fees. Priced rounds may involve more detailed term sheets, outlining a number of variables that will affect the outcome of your investment.
For investment rounds, there’s no one-size-fits-all structure. Just as every company is different, each deal you come across will look a little different.
Understanding the different investment structures will allow you to build an approach that works for you and for the companies you invest in.