Whenever you invest in a startup, especially through a funding portal, it is important to understand what type of financial instrument you are buying. This can be one of the most complicated and opaque parts of the process, but it will affect whatever returns you earn, so as an investor it is important to understand the terms of your investment.
There are three main instruments used by funding portals: stock, convertible notes, and SAFEs.
What is it? Common stock is usually the most familiar form of equity to investors. Common stock is a fraction of ownership of the business, not debt or future promises of equity, which I will discuss later.
Preferred vs. Common. There are general two types of stock in any company, common and preferred. Common stock is the standard stock issued by a company. This is the class of stock usually held by founders and employees of the company. When investors purchase common stock they are getting the same form of ownership as the founders, which can align their interests. Preferred shares usually come with “preferences” that give investors some protections against downside.
Important Terms. When purchasing common stock, investor should look at two terms: voting rights and transfer restrictions.
Voting rights will give you, as an investor, a small say in how the company operates. Now, unless you are making a big investment, you shouldn’t expect to have any real control over the company (similar to purchasing any public stock, such as Apple or Tesla), but it is good to understand what your rights are.
Returns. Transfer restrictions will determine how you will get a return on your investment. For example, all stock sold on Netcapital can be sold at any time on our secondary transfer platform. This allows investors to get liquidity on their investments. Investors should be aware that the ability to sell shares does not necessarily mean there will be a market for those shares.
What is it? Convertible Notes are a popular funding instrument for startups. They are debt, and usually earn interest just like any other loan. The difference between a convertible note and regular debt is that convertible notes can be converted into stock upon a future “qualified financing”. Usually a qualified financing is a sale of over $1 million of preferred securities. Convertible notes are popular because they allow founder to delay valuing their company, which is notoriously difficult to do at an early stage.
When investing in a note through an equity crowdfunding portal, it is important to understand the terms of the note. Until the note converts, you do not actually own any portion of the company. Additionally, it is important to understand if the company has the right to simply pay off the note plus interest.
Important Terms. Important terms to know: Interest rate, discount, valuation cap, conversion triggers
A standard interest rate is around 6%, while it is important to understand what interest your investment is earning, don’t worry about a 4% or 10% interest rate. At the end of the day, investing in startups is too risky to just want a 10% return, you want a 10x return, so the interest rate, at the end of the day, won’t likely change your economics much.
The standard “discount” on a convertible note is 20%. This means, that upon the next “qualified financing” the value of your note, as a reward for investing early, is converted into stock at a 20% discount from the other investors in that round.
The valuation cap is the maximum value at which your note will convert. For example, if your valuation cap is $10 million, but the company is valued at $20 million during its next financing, your note will purchase stock at a price per share equal to a $10 million valuation. This is a great result for investors. The lower the cap, the more investor-friendly the note.
Returns. In a scenario where the notes are still outstanding and a company receives an offer for purchase, it may be better for founders to pay off the notes and retain the equity for themselves, leaving investors with just interest (not enough return to justify the risk of investing in a startup) and missing out on the huge upside of an exit.
What is it? SAFEs stand for “Simple Agreement for Future Equity”. SAFEs are similar to convertible notes, but they are not debt. They are just a pre-purchase of equity, which will be exercised during the next company financing. Like convertible notes, SAFEs allow founders to delay putting a valuation on their company, while also avoiding having debt hanging over the head of the company. High growth startups rarely have capital to pay off debts, as they put all their cash toward growth.
SAFEs sometimes have interest, sometimes they do not. Investors should understand the terms of the SAFE.
In particular, it should be noted when the SAFE will convert to equity. On Republic, the SAFE gives the company the option to convert the SAFE, or roll it over at any financing. What that means is that, if there is an acquisition offer, you could end up with just the discount, and not the whole upside, despite taking a risk and investing early.
So what should I invest in?
What you, as an individual investor, decide to invest in is a personal decision. You should always understand the terms of the deal, but at the end of the day investing in startups is risky and no amount of investor-friendly terms will fully protect your investment. Investors should take into account their need for liquidity, risk tolerance, and the potential of the company selling the securities when evaluating an investment opportunity.
Wall Street has Morningstar, S&P, and Bloomberg
The equity crowdfunding market has KingsCrowd.
About: Rob Burnett
I work for Netcapital doing business development. I am passionate about working with entrepreneurs and helping them raise capital.