Limited liquidity is a crucial issue for most new start-ups. Unfortunately, raising equity capital can be one of the most difficult and stressful steps, especially when the business has a novel product or service, because there is no established track record.
To attract debt or equity investors, owners are faced with the dilemma of declaring an imprecise value for their business, when, many times, there are no concrete metrics for what the business is currently worth. This results in the use of future projections that may or may not be realistic. Many investors are reluctant to invest purely on the basis of projected cash flow.
Similarly, owners take a risk when raising money based on projections. If the declared valuation is much lower than actual results, the investors will be pleased. However, the business owners will regret having given away so much equity for so little capital.
On the other hand, if the owners value the business too high in the initial fundraising, they may not succeed in raising enough money.
Convertible Notes or SAFES – A Solution
Convertible notes and similar instruments, such as SAFES, provide a way to mitigate this guessing game and to secure crucial early-stage funding to get a company in motion. The primary advantage of these installments is that they allow both the business owners and the investors to postpone the valuation discussion to another day.
Convertible notes or SAFES generally convert into equity (usually at a discount) based on the valuation of the company’s next financing round. This conversion allows early investors to capture a premium for taking early stage risk, while protecting business owners from undue dilution. Convertible notes provide a bridge to get the company in position for a larger equity financing round in the future.
Looking to raise funds for your business?
If you’re thinking of raising capital for your business, contact us to discuss what options are best for your company’s situation.