Authored by Entrepreneurs’ community in collaboration with VCPEA
Equity-based investment, while potentially beneficial for startups in their growth stages, often presents complexities and challenges that make it less ideal for the earliest phases. In these initial stages, a startup’s valuation may not yet warrant equity issuance. Consequently, diluting equity in exchange for early-stage funding can be particularly costly for the entrepreneur.
A key consideration is that each subsequent fundraising round typically necessitates issuing new shares. This process incrementally increases the total number of outstanding shares, leading to further dilution of the founder’s ownership stake. Furthermore, equity holders frequently seek input in decision-making, which can divert the entrepreneur’s focus from executing their core vision for the startup.
When an investor expresses interest in providing early-stage funding, several alternative investment instruments become available. These include Convertible Notes, often structured as a Simple Agreement for Future Equity (SAFE), as well as Convertible Debt and Keep It Simple Security (KISS) agreements.
Convertible notes are straightforward financial instruments frequently employed by startups seeking early-stage capital. Essentially, these instruments represent debt that can be converted into equity upon the occurrence of specific predefined events. A significant advantage of convertible notes lies in their ability to bypass the often complex and premature valuation of a nascent startup. Instead, the focus shifts to evaluating the startup’s operational stability, a particularly relevant factor for early-stage companies that may not yet have generated substantial revenue or accumulated significant assets.
Furthermore, convertible notes offer a cost-effective fundraising solution for startups compared to more traditional investment methods. They also present a compelling proposition for investors, combining the security of debt with the potential upside of equity ownership and other beneficial terms, thus fostering a flexible and mutually advantageous arrangement.
At their core, convertible notes are debt instruments issued by a company that grant the holder the future right to convert the outstanding debt into a predetermined number of the company’s common shares at a specified exchange ratio. This mechanism allows investors the option to transform their debt into equity in the startup at a price established at the time the note was issued—often including a premium over the prevailing market value. The ability to exercise this conversion right typically arises on a specific future date or within a clearly defined timeframe.
From an investor’s perspective, convertible notes offer a strategic advantage by providing a claim on the underlying value of the company’s assets while mitigating risk. The primary appeal for investors lies in the potential for significant returns upon conversion to equity, often exceeding the typical dividend yields associated with standard common shares.
In 2013, the landscape for early-stage startup funding often involved small capital infusions before formal funding rounds. Recognizing this challenge, the global accelerator Y Combinator introduced the Simple Agreement for Future Equity (SAFE). This innovative instrument offered a rapid and uncomplicated method for startups to secure larger early-stage investments, quickly gaining significant traction within the startup ecosystem.
Subsequently, a few years later, 500 Startups—now known as 500 Global—developed the Keep It Simple Security (KISS) in response to perceived limitations in investor protection within the SAFE agreement. Further refined in collaboration with Silicon Valley law firms, the KISS agreement became a widely adopted tool for 500 Global’s investments and was made freely available to the broader public.
Consequently, convertible notes have emerged as a common debt-like instrument utilized by early-stage startups to obtain funding. These notes function as loans that are typically designed to convert into equity during future funding rounds. Notable examples of convertible notes include the Simple Agreement for Future Equity (SAFE), pioneered by Y Combinator, and the Keep It Simple Security (KISS), developed by 500 Global.
Simple Agreement for Future Equity (SAFE): The SAFE (Simple Agreement for Future Equity) is a funding contract designed to streamline early-stage capital raising for startups, avoiding the complexities and high costs of traditional venture capital financing.
Crucially, the SAFE itself does not grant an immediate equity stake. Instead, it outlines conditions that, upon being met (typically reaching a specific funding milestone), trigger the investor’s right to acquire equity in the company.
Given its prevalence in early-stage funding, initial investments through SAFEs are generally smaller than in later rounds. This structure mitigates risk for investors while enabling them to participate in promising, high-growth potential ventures.
Convertible Notes: Convertible notes operate like a form of quasi-formal debt, accruing interest until conversion or maturity. The typical process involves an investor loaning capital to a startup. Instead of traditional repayment with interest, the investor receives equity in the company, often with accrued interest being added to the investment amount upon conversion.
These notes include maturity dates, specifying when the loan must either convert to equity or be repaid. In some instances, mandatory conversion to shares replaces the repayment option.
Keep It Simple Security (KISS): Introduced by the startup accelerator 500 Global, the Keep It Simple Security (KISS) agreement is a type of convertible note akin to the Simple Agreement for Future Equity (SAFE). However, unlike a standard convertible note, the KISS agreement incorporates both a valuation cap and a discount for the investor.
Typically, the KISS agreement converts into preferred shares during subsequent funding rounds if the investment surpasses a predefined threshold (e.g., over $1 million) or upon reaching its maturity date. Designed as a streamlined alternative to traditional convertible notes, the KISS aims to simplify the fundraising process for both startups and investors.
While all three types of convertible notes serve the same core purpose—facilitating capital raising for startups—they present distinct levels of complexity and offer varying benefits. These key differences dictate their suitability for diverse circumstances.
The Simple Agreement for Future Equity (SAFE) stands out as the most straightforward to implement. Its lack of interest and maturity dates provides a notably simple structure. Conversely, convertible debt introduces greater complexity through its loan structure, accrued interest, and defined maturity dates, often making it a less desirable choice for early-stage ventures.
The Keep It Simple Security (KISS) agreement shares fundamental similarities with the SAFE but introduces potential variations. Specifically, a KISS note may include maturity dates, interest rates, and additional “investor rights,” adding a layer of customization not typically found in a standard SAFE.
Convertible notes appeal to investors seeking a blend of fixed income and potential equity upside. For example, while they generally offer a lower interest rate than traditional bonds, the valuable option to convert them into common stock provides an attractive potential for higher returns.
Venture capital firms commonly utilize convertible notes as a funding mechanism for early-stage startups. This approach allows them to invest smaller amounts initially when revenue is limited, granting them the flexibility to assess the startup’s progress over time before committing to larger future investments.
From an entrepreneur’s perspective, convertible notes offer a strategic advantage by facilitating early-stage venture funding without the immediate need to cede equity.
Convertible notes present a spectrum of advantages and disadvantages for startups, requiring careful evaluation against their specific needs and objectives to determine suitability.
For investors, a key advantage lies in receiving fixed interest payments while retaining the valuable option to convert the note into equity, capitalizing on potential share value appreciation. Furthermore, these notes offer a degree of downside protection, as noteholder payments take precedence over those to common stockholders.
From the startup’s perspective, convertible notes facilitate capital acquisition without immediate equity dilution. Moreover, they often allow for lower interest rates compared to conventional debt instruments, positioning them as a potentially cost-effective financing avenue.
Conversely, investors or lenders accepting convertible notes typically face lower interest rates in exchange for the potential upside of equity conversion. However, this potential benefit is accompanied by an increased level of risk for the investors.
For startups, the conversion of notes into equity can dilute ownership stakes, potentially impacting the share price and altering the dynamics of earnings per share (EPS) negatively.
While startups can leverage convertible notes at different points in their funding journey based on their specific needs and investor dynamics, they are most prevalent during seed funding and bridge financing.
Seed Funding Rounds: In their initial funding rounds, early-stage startups frequently utilize convertible notes for financing. This is common when the company is still refining its business model, developing its product, or evaluating market fit.
Angel investors and early-stage venture capital firms often provide these notes to supply capital while postponing valuation discussions until a subsequent round, where increased data and traction can support a more accurate assessment.
Bridge Funding Rounds: Convertible notes frequently serve as a crucial tool in bridge funding rounds, which strategically bridge the gap between two significant funding stages. These notes offer startups vital short-term capital, enabling them to maintain operational momentum until a more substantial funding round is successfully secured.
Startups often leverage bridge funding to ensure continued operations while actively pursuing further investment or working towards critical milestones. Within these bridge rounds, convertible notes provide a mechanism for startups to access necessary capital swiftly, bypassing the immediate requirement for a formal valuation process.
The key terms of the investment, including the utilization of convertible notes, are typically defined and formally documented in the term sheet agreed upon by both the startup and the investor.
Several organizations in Saudi Arabia offer term sheet templates to facilitate investment processes. For example, the Saudi Venture Capital and Private Equity Association (SAVCPEA) provides resources aimed at empowering and developing the venture capital and private equity sectors, while also fostering connections within them. Similarly, Oqal Group, a platform that connects angel investors with startup founders, also offers such templates.
Specifically, the Saudi Venture Capital and Private Equity Association (SAVCPEA) offers a complimentary term sheet template, developed in collaboration with a law firm and a consulting firm, which is readily available for download. Likewise, Oqal Group provides a free term sheet template that adheres to Islamic law and is accessible in both Arabic and English.
Oqal’s template comprises two distinct sections: the first outlines financing as a Qard Hasan (an interest-free loan), and the second details a promise for the future sale and transfer of share ownership. This template is also available for download.
While securing funding through convertible notes might not be the most prevalent method, it remains a viable option for startups. This approach can be particularly useful when companies encounter obstacles that complicate equity financing or when they need to secure capital swiftly without immediately establishing the company’s valuation.