Shutterstock 2179493077

Raising capital

Almost all start-ups will need to consider raising capital to support turning their concepts into a functioning product or service business. To help with their capital raise, founders turn to investors to request that capital in exchange for equity to support them on their quest.

There are two key ways that startups can do this which is to either issue shares (equity) in exchange for the capital upfront (in a priced round), or by using ‘convertible debt’ - typically in the form of Convertible or Simple Agreement for Future Equity (SAFE) notes. We’ve found a good article that details the differences between convertible and SAFE notes in New Zealand from our friends at LegalVision.

Why use Convertible or SAFE notes?

Both a Convertible note and a SAFE note are short-term debt that will eventually convert to equity, and it can have a few main advantages for a startup:

Quick to process

A startup can complete a convertible note transaction in a matter of days, and takes much less time from lawyers to process.

No sharing of control

Control rights are very uncommon with convertible and SAFE notes meaning that you do not have to grant rights to control certain aspects of your business such as a board seat or veto rights.

Delay valuing the startup

It can be difficult to value a business at the start of their lifecycle as there is little data to go off. Convertible (and SAFE) notes can be a good way to avoid this task until the next official pricing round. The benefit to the note investor is receiving a discount to whatever the priced round valuation will be.

SAFE notes do not have a return

They do not have a term associated with the debt, and don’t typically incur any interest.

How to model the dilution of Convertible or SAFE notes

A lot of startups are unsure whether using a Convertible or SAFE note is right for their business, and part of this may be due to not understanding how costly they are. By issuing these types of instruments, a company will permanently give some of their equity away which can be more difficult to estimate the cost of equity vs debt. Variables such as a future valuation discount, valuation cap, coupon (ie. interest rate, where applicable) and not having a set valuation, does make it a bit more tricky to work out what the outcome (dilution to existing owners) of the Convertible or SAFE note may be.

The team at Orchestra have come up with a helpful Convertible or SAFE Note Dilution Calculator to help startups determine whether this could be a viable option to inject more capital into their business.

Download a copy of the Convertible or SAFE Note Dilution Calculator to tailor it specifically to your business.

Convertible and SAFE Note Calculator

Download calculator

Here’s a quick breakdown of what’s needed to help with the calculation:

1. Understand your position today

Add in your business current position including the outstanding shares and total options pool which gives you the fully diluted capitalisation.

2. Enter the terms for your Convertible or SAFE notes

Include any interest rate (if applicable), the discount you are willing to pay with these notes, the valuation cap, when you anticipate to draw-down the capital.

We then need to establish the milestone which will convert the notes into equity, which is typically at the next round of a priced capital raise (i.e. a Series A capital raise). This is what we’re assuming to take place as part of this modelling.

3. Enter details of your future raise

Include the date of your next raise, the pre-money valuation you’ll have at the next round and what you plan to raise. This will then help to model the share price of your next round, the note conversion valuation and price (including the discount applied).

4. Dilution and ownership changes

Based on what has been determined above, you will be able to see how much today’s equity holders will be diluted by. For example, if the dilution rate was 20%, a shareholder who owned 10% of the business would drop to 8% (10% * [1–0.2]).

Please note that this calculator has made some assumptions, including:

  • RWT of 33% has been applied to any interest earned on the note. Withholding tax would typically vary depending on the situation of each investor.

  • Rounds up to the nearest share. You may decide to round down and refund investors the difference.

To recap, early stage companies may often be unaware, or reluctant to use other instruments, such as Convertible or SAFE notes to help them bridge into a future round of funding due to the concern of dilution. There can be advantages of using these instruments which is why it is worth utilising this calculator that aims to show the impact of dilution for existing equity holders and help you consider the right balance of note offer terms.

We hope you find this to be a useful tool for consideration in raising investment to support your business. If you decide to raise a Convertible or SAFE note, Orchestra can help you ensure this transaction and the investors are managed alongside your overall share register and cap table.

Speak to one of our team if you would like to find out more.