In the United States, the most talked about form of early-stage financing is Venture Capital. And for good reason - according to the National Association of Venture Capitalists, in 2020 10,862 startups took in $164 billion in VC funding, the third year in a row that over $130 billion has been invested.
However, VC funding is only part of the picture - and often isn’t the right means to get capital for many small companies. And even startups that go on to raise large amounts of VC dollars often start with other types of capital, from founder funding to cash from actual customers to angel investments.
Preferred stock or preferred equity is a special type of equity used by VCs because it comes with a large number of specialized rights and privileges that make it superior to the common stock that founders and stock option-holders (i.e. employees) get. These rights include a liquidation preference, which means the venture capitalists get their money back before common shareholders. Plus they usually have the right to block major decisions like exits, fund raises, debt, etc by voting as a class.
Convertible notes, usually called “converts,” are one of the top forms of financing used by professional investors. Their popularity has decreased after the creation of SAFEs, but converts are still one of the most common types of investments raised by startups at the seed rounds, as well in extension rounds. Learn more about convertible notes.
SAFE notes (“simple agreement for future equity”) is a very simplified agreement that mimics a convertible note. It was designed by Y-Combinator to make easier to finance a startup, with less paperwork and lower legal costs. Of course, over time, SAFEs have become more complicated, so what used to be a simple, one or two page documents are now a multi-page legal agreement. However, there are advantages of SAFES - they are very fast vs. most convertible notes to paper, don’t have interest or a maturity date. Big things to watch out for are conversion valuation caps, “the Cap,” and pre-or post money on the conversion discount and cap. This can make modeling the cap table pretty difficult.