A foreign client out of Korea recently asked me if I thought a convertible bond was an appropriate instrument by which to invest in a US startup company. During our discussion, I learned that convertible bond was a very popular instrument of Korean venture capitalists. After the discussion, we decided that convertible note was appropriate.
But this discussion led me to think about some of the ways I see investors invest into startups. I am keeping this discussion to c-corporation only. LLCs, the other popular vehicle, could have added complications especially with regards to the tax consequences of the equity owners. But even with the LLCs, the basic characteristics should apply. They are:
- Common Stock
- Convertible Note
- Preferred Stock (usually convertible)
- Simple Agreements for Future Equity, or SAFE
COMMON STOCK is perhaps the purest ownership interest in a business entity. Generally speaking, it is the voting shares of a company, which also signifies the fractional ownership interest, that a typical founder of a company would have. In its core, a common stock owner owns the fraction of the company represented by the number of shares the owner owns divided by the total number of shares outstanding.
And because it generally does not have any special rights associated with it, so long as the company (if corporation) has issued enough shares, there is no need to amend such corporation’s charter (come common names for a charter are certificate of incorporation, articles of incorporation, etc.).
For an investor, however, common stock (especially of a startup, which generally is thought of as riskier than a mature company) may not be sufficient. For example, since everyone has the same rights, it necessarily lacks certain privileges, protections, or rights that an investor may want. Chief among such privileges, protections, or rights, may be the protection against the risk of dilution. Because startups tend to need to lure talent by promising certain equity stakes in the company, usually through stock option or restricted stocks, an investor risks future dilution of its shares without any protection in place.
PREFERRED STOCK, which is a catch-all term for shares that have a preferred position over the common stock in liquidation, generally combines some debt-like qualities along with equity. A preferred stock could have other rights, limited only by imagination and some practical concerns.
A typical “funding round” in a startup (Series A, Series B, etc.) company is done through preferred stock. It typically includes certain dilution protections, right to convert into common shares, certain annual return on investment (or internal growth of the value of the convertible shares instead of cash payment), preferred position in liquidation, and sometimes liquidation multiples. Sometimes preferred stocks could vote along with the common stocks. Preferred stocks are well-understood by other investors.
But since there are many different aspects that need to be negotiated, the time and cost of effectuating such investment could be long and high. Most likely, the company would also have to amend its charter to reflect certain rights.
CONVERTIBLE NOTE, or really, any convertible debt, is perhaps the most popular way that I see for early stage investors to invest into a startup. Convertible note is basically a simple debt that, either at a certain triggering event or at the lender’s choice, converts into common stock at a previously agreed upon price.
Because the investment acts as debt prior to conversion, it is quite simple. There is generally no need to amend the charter or to involve other legal heavy-lifting that perhaps a preferred stock might need. Sometimes, parties even agree to the type of equity into which the debt would convert, but would not do the legal work until conversion happens.
But because it is debt, the company is likely having to service the debt. And even if the investor is willing to forego the periodic interest payment the convertible debt generates, the convertible note eventually mature. When the debt matures, the investor could demand a large cash payment back, which could potentially cripple the operation of the company or, worse yet, threaten the existence of the nascent company.
Sometimes, convertible note can also contain complicated privileges, protections, or rights for the investor.
SAFE is probably the simplest way in which an investor could invest into a company. There is no maturity date. Generally, there is also no interest accruing. The lack of features also means likely an investment through SAFE favors the company.
SAFE, however, is also likely the least common method of investment, and therefore an investor may be least familiar with it. And that unfamiliarity could mean more uncertainty for investors. And unfortunately, an uncertain investor is an investor who is less likely to pull the trigger. Another way to put it, it may be more difficult for a company to find an investor who is willing to invest into the company via SAFE.