Andy Tang explains convertible notes and SAFEs for startup financing. He covers valuation caps, discounts, and when to use each instrument instead of preferred stock. The talk includes questions from the audience about how these mechanisms work in practice.
Chapters
Is that too expensive? So we did 2 things. Basically as an institution we would invest enough so that overhead is percentage-wise low. 2, there is something called a Series Seed. So now there are standard terms for preferred stock, you could get it for pretty cheaply, you could get law firms to do it for $10,000. So things are changing. So our advice to entrepreneurs is try to bootstrap to this point, minimal viable product, and raise $500,000 to $1 million through preferred financing. So you have enough of a scale. But if you must, if you need to raise $250K, do a convertible note, that's fine, and they'll cost you $2,000 to $3,000. But as an institution, we just— we prefer to be in a company where everything is spelled out very clearly and don't have any sort of moving parts. With SAFE, lots of moving parts, and with convertible note, some moving parts. But if you need to raise $250K, it makes sense to go convertible note. Does this make sense? Right? Hopefully I didn't repeat too many things that the professor said, right? Good. Okay, so let's skip this.
Yep? What do you think is the minimum amount to have a preference stock?
Minimum round of financing for— Different people give you different answers. For me, it's $1 million.
Yep. Can investors go back and forth like from loans to stocks and back to loans?
Explain that again.
Yeah, so can investors go back and forth like saying if it's scaling well, they change it to stocks?
Oh yeah, okay. So the question is, can investors go— can a company, not investor, can a company start with Convertible note and then prefer financing and then go back to convertible note again, right?
No, I mean it's the investors who choose to actually convert their loans to shares, right?
Yeah.
So if it's not scaling well, I mean they can make—
No, no, no, once you convert it, typically once you convert it, it's done. It's a one-way street. Yeah, good question though. So the question is, You have a convertible note. You decide I'm going to convert to stock and the company doesn't do well, can you then convert back and say I want my loan back? Typically you can't. I'm sure if you go to Wall Street someone could design you a financial instrument that could go back and forth, but for this purpose in Silicon Valley, the simple startup financing, it's a one-way street. You're a convertible—
Debt.
debt holder and if you see things are going well, you could convert it and then once you convert it, become a shareholder. Yeah, good question.
Andy?
Yeah, please.
Beyond like $1 million, people don't do convertible notes, is it?
No, sometimes they still do. I mean, you see convertible notes of even larger and for different rationales. Let's say you're a Series B company, you already raised $100 million, and then you might need $5 million to go to the next round, but you may— you don't want to do full equity financing because $5 million to them is small. So you would just have people invest in the convertible note that will convert to the next round of financing, right, because you're not— you don't have time to— Raise $100 million, your next raise is $100 million, but you only need $5 million to get to that stage, you take in a little bit of money. You kind of delay the proper equity financing. Does that make sense? So think of convertible note as just a delay of a proper financing.
Right.
You could use that at the early stage, you could use that at the late stage.
I understand this convertible note used when you don't understand how maybe clearly make evaluation of the company. So the next investor make this valuation and you take a part of the company, yeah, this is the first step.
Yeah, so that's exactly the reason. So let me repeat that for the class. So one of the key features of a convertible note is it's a Delay of setting valuation. Delay of setting valuation. So let me repeat that. So you do a convertible note so you don't have to set a valuation right now for whatever reason. So for instance, one reason could be you're an inside investor, you're an existing investor, you may have a conflict of interest in setting valuation. You just want someone else to set the valuation. Because you're an insider, you may be overly optimistic about the company, right? Or you're a friend and family or angels, you don't want to set the valuation because you don't know how to set valuation. You basically say I'm going to do a convertible note and tell someone else, a knowledgeable third party, to come in and set valuation. And now simply convert at that valuation. Maybe at a discount because I came in a little bit earlier.
If you invest $10,000 now with convertible loan and the next investor states that the company was like they company grows and then in a year they invest for example $10 million and you as the investor invest just one hundred. How do they make your stock— how do they understand?
Okay, so let me try to rephrase your question. I think basically what you're saying is there's a disadvantage of being a convertible note holder because you invest and then the company makes progress, the valuation goes up, why would you want to convert at that high valuation, right?
Because better you invest when the company is much smaller and you're Yeah, so let me explain.
There's something in the convertible note, there are a couple of features, 2 key features to remember, and this will probably apply to all of you very soon. If you raise a convertible note, right, let's say if you raise $200,000 from friends and family and instead of giving them a loan you say, well, let's do a convertible note that converts at the next investor or next equity financing. You need to look at 2 things. One is the discount and the other one is the maximum conversion rate valuation. The discount is simple, right? So, I invest now in a convertible note and someone else comes in and they invest at $10 million valuation. I would have a discount, say 20%, and I would invest in a valuation of $8 million.
Why?
Because I came in a little bit earlier.
Right?
That's one feature. Feature number 2, I may have a cap, right? I may have a cap at $2 million because I came in really early. My $100,000 at $2 million reflects the state of the company, right? So someone else may come in at $10 million, but I'm going to raise my hand and say, excuse me, you come in at $10 million valuation, But I invested 8 months ago and I have a cap or a maximum valuation conversion at $2 million, so I actually would own more shares. I come in at a cheaper valuation. Does that make sense?
And they just deal with what will be the right way, yeah?
Yeah, so he said do they then just deal with the right way, i.e., do the lawyers do all the arithmetic to figure out the right shares?
Yes.
Some simple arithmetic they can handle. Yeah, good? All right, let's talk about something even more important.
