Modern startup funding

I, like Kevin said, I'm gonna talk about modern startup financing. I have only been practicing law for twenty one years. So what's old and what's new only spans that time frame for me. But I've seen a lot of changes to the startup ecosystem. YC's been a big part of a lot of the changes to the startup ecosystem and the way that financing is done. So I picked this picture.

These are called closing volumes. And every corporate lawyer who does private company or public company financing has a lot of these if they have been doing it for long enough. The legal teams used to get these bound volumes with all of the financing documents in them. They have our names on them and the date. So this doesn't happen anymore. But I just thought this was I saved some of mine.

I thought this was a good picture for this. So a lot of you are going to already know what I'm about to talk about. But since this is startup school, I just want to give some basics. So you have a company idea. And the first thing you're going to do is form a corporation because it's a separate legal entity, and it protects the founders from personal liability. Right? We all know this.

You can probably bootstrap it. You and your cofounders can bootstrap it for a little while, but eventually, you're going to want to hire or grow, and you need money to do that. How do you do that? You can go ask your relatives for money. You can go to a bank and ask for a loan. Or what most startups do is they sell a part of their company to raise money.

So when you, as founders, you guys will buy common stock. That's how you become owners of your corporation. And typically, you will buy common stock for fraction of a penny. You may contribute some intellectual property as part of that purchase. But basically, you're gonna be buying your stock and own a % of it for nothing. You cannot raise a meaningful amount of money by selling common stock.

So your option is to sell to investors a completely different class of stock called preferred stock. Preferred stock is more expensive. Before another kind of basic thing, I never know what the you know, what what kind of terminology people know. So I thought it'd be really helpful to take a look at this. These terms right here.

So first of all, financing and round, they mean exactly the same thing. Preferred equity financing, preferred stock round, preferred stock financing, series a financing, series seed financing, these things all basically mean the same thing. It's fundraising by selling preferred stock at a calculated specific price per share.

These terms, convertible round, note round, safe financing, we're gonna talk about what the safe is, early stage round, early stage financing. These are all ways to describe a fundraising event where you're not selling preferred stock or common stock. You're selling convertible securities. Convertible securities are the right to get stock in the future. It's a thing that it's not itself stock.

It converts into stock later. So I think that there are about three things that have changed a lot over the years. And the first one is structure. And by that, I just mean that the actual document that we use for early stage fundraising has changed. And I'm gonna talk about that more in a few slides.

The other thing that is hugely different from the old days is access because nowadays, you can find fundraising documents online. And, you know, they come with annotations and esignatures, and it's just incredibly easy to get documents.

Back in the olden days, the only way you could fundraise was by hiring a lawyer because there was no way to get the documents you actually needed to sell your preferred stock. And the other thing that I think has changed a lot over the years is focus.

I just remember I don't ever remember anybody ever noticing how much time it took to do these financings in the past and how much focus it took away from founders building their company. I don't remember an investor or a founder ever saying, gosh, this is taking a month and a half. I'd so much rather be building my company.

I think today people notice and have figured out that it's not in anyone's best interest for people to be spending a lot of time fundraising. So it's much faster. So what hasn't changed? Preferred stock financings are no longer the way that companies raise their first do their first fundraising. But that process and those documents themselves really haven't changed over the years.

And I'll talk about that a little bit more in a second. But that's pretty much the same. It's just the when that's changed. The other thing that hasn't really changed, is I think there are two things that are super important to investors and to founders when they're fundraising. And those two things are valuation and dilution. So valuation is just the value of your enterprise.

And dilution is stock, like how much, you know, how much of your company have you sold. So if you are selling investors a percentage of your company, you previously owned 100% of it. After you sell some, you're not going to own 100% of it. That's dilution.

And then the last thing I just really wanted to add in here because I think it's really important to get this point across to people who are starting startups. Communication with investors has always been important because this is fundamentally about a relationship. Right? Investors are giving you money. And you are being expected to take their money and turn it into a billion dollar business.

Whether or not you are succeeding or failing at that endeavor is so critical to communicate with your investors about that. So I think that that's something that has not changed over the years. It's still super important to communicate. So as I mentioned before, the old way of raising early money was to do a series a preferred stock financing. A is the first letter of the alphabet.

So the first time that a startup would fundraise, it would be called a series a preferred stock financing. Okay. How did it work? So we take the valuation of your company, which is the overall value of your enterprise. You would divide it by the number of outstanding shares of capital stock. That's mostly for a series a financing, just be the stock that the founders owned.

And that gets you a price per share. You take that price per share, and you would sell your preferred stock to your investors. So now, well, back then, angel investors I'm sure you guys have heard about angel investors. They used to aggregate into consortiums, and so they would tend to all band together and write one big check.

So for your series a financing, you would have maybe a couple of angel groups, and you would raise about 1. 5 to $2,000,000 in your series a preferred stock round. Angel groups now write individual checks. Doesn't really happen, like, in consortiums anymore. Anyway, then you would negotiate the terms of the preferred stock.

So the lead investor and you, the company, would have you each get your own legal counsel. The lawyers would go back and forth. They would negotiate the terms of the preferred stock, which means voting rights, liquidation rights, pro rata rights. And then you'd end up with a set of documents that go in those closing volumes. And there's about five of them. This took months.

And it could cost anywhere in legal fees from 25,000 to $100,000 Okay. So what's broken about that? Well, that's pretty elaborate. Right? Takes a long time. It costs I just told you it could cost, you know, 25 to 100 k on legal fees to do this. So it's kind of a big deal. But I think that the thing that was most broken about it was how inflexible it was.

Jared's probably going to touch on this. It used the the cost of starting a company has decreased a ton over the years. Not so much for software and ecommerce companies. I'm sorry. Not so much for hard tech companies, but software and ecommerce companies, the price of actually starting these startups has way decreased. And as a result, companies actually don't need to raise 1.

5 to $2,000,000 just to get off the ground. And having to do these long, elaborate, expensive financings was not worth it. So it just wasn't at all flexible. So when a company would do a big series A round for its first round and then it was waiting to do its series B financing, sometimes it would run out of money in between.

And so oftentimes, the company would then go to its lead finance its lead investor, rather, in their series A financing, and they would ask for a bridge loan. A bridge loan is a debt bridge between two financings. And these involve the note purchase agreement and a convertible promissory note. And sometimes there would be common stock warrants that would go with it.

But basically, it was a stopgap measure in between financings. So again, keep in mind, these financings I just told you were long and expensive. So you aren't just doing them all the time. And this is where bridge loan financings came in. At the heart of the of the bridge loan was this convertible promissory note. And a convertible promissory note was a loan. It had an interest rate.

It had a maturity date. It was a real note, but it also had a mechanic that would cause it to automatically convert into shares of stock when you did that next round. So if you got a bridge loan in between your series a and your series b, your convertible promissory notes would convert into shares of series b when that financing happened.

But along the way, and I honestly don't remember how this all came about, but people started to realize that just the convertible promissory note, not necessarily the note purchase agreement or the common stock warrants, but the convertible promissory note itself could actually be used as a stand alone document, and you could use it to fund companies, and you could use it to fund not as a bridge, but actually just the very first time that a company needed money.

So this became a very appealing way to do your first fundraising event because instead of having all those documents I described in the series a financing, instead, you just had a convertible promissory note, which was obviously gonna be a lot faster. It's only one document.

You you people still hired lawyers for these convertible notes, but only negotiating one document, and you're only negotiating maybe maturity date and interest rate.

Lots cheaper and lots more flexible because now instead of being you know, having to do this elaborate financing process and probably wanting to raise a couple million dollars to justify all that effort, you could just raise 50 k from an angel. You could raise a hundred k from an angel or even less. But it's still a promissory note, and a promissory note is still a loan. So it's debt.

We then at YC decided that we could modernize even the convertible promissory note, and what we did is we came up with something called the SAFE. The SAFE is an acronym. It stands for simple agreement for future equity. And like the promissory note, it is one simple document. It is a convertible security. So when we went I showed you all those terms. It's a convertible security.

It converts into stock when the company raises a priced round. You don't need to hire lawyers to do a SAFE. It's available online. And the most important part of it is that it isn't debt, which is why it needed to exist. What was broken about convertible promissory notes? They were only one document. They were cheap. They were fast.

Well, because we didn't think it made any sense to use debt to sell equity. Angel investors are not lenders, and, startups don't really want to be borrowers. Right? The whole point of taking someone's 50 ks and turning it into a billion dollars is everybody those investors want to be stockholders.

And start ups don't want to be thinking about accruing interest or, you know, when is their note going to be due. So we thought that it made a lot more sense to take all the debt piece all the debt part out of convertible promissory notes but retain all of the the convenience of them.

So I could do an entire lecture on how to use the safe and what it's all about, but I've actually already done that. So there are, other start up school video lectures that you guys can watch to hear a ton more about the safe. The this is a this is the YC page. This is the resources tab. So SAFE financing documents are at the top.

We have a user guide that is kinda long, but it has a ton of really good information in it, tons of math examples to use to show you how it converts. So please visit that. Then the SAFE is only five pages long. It has the word simple in it, right? It's actually really easy to read. So then the question is, when do price rounds happen? They are still the primary way that startups raise money.

They're no longer the way that most startups raise their do their first fundraising. But built into the SAFE and other convertible securities like promissory notes is the whole concept that eventually the company is going to do a priced round, and those convertible securities are going to convert into that priced round.

So most often, companies will do their first fundraising on a safe convertible promissory note, and then they will do a priced round afterward, and all of those safes and convertible promissory notes will convert into stock. Safes and convertible promissory notes cannot convert unless there is a price run done eventually. So so price rounds are still modern.

They're just not the modern way to raise your money the first time. And, also, I should mention priced rounds, even though I was kinda laughing at them because they involve a lot of documents, and we used to put them in these leather bound closing volumes for the lawyers to put on their bookshelves. They have actually seen some improvements as well.

They are much more standard than they used to be, and they are also all five of the price round documents, you can get them online these days. Everyone tends to still hire a lawyer for them. Okay. So did we perfect modern early stage financing by introducing a SAFE and by, you know, everybody using convertible securities to raise money the first time.

And I would say we've come a long way, but I don't think it's quite perfected. And the reason is because I mentioned dilution a few minutes ago. So convertible securities, because people who hold investors that hold convertible securities are not stockholders, you actually don't it's very hard to to tell how much ownership of your company you have sold when you sell sell convertible security.

They're not on your cap table as stockholders. Right? You're still 100% owner if all you've ever done is sell convertible securities. But the day of reckoning is coming when you do your priced round and all those convertible securities convert into shares of stock. You have to keep track. And there are a ton of resources and tools on how you can keep track, but you gotta do the work.

There's no excuse for being surprised by realizing you sell 30% of your company to to all of your angel investors. So so don't let that happen to you.

The other thing has that is to be aware of with early stage fundraising using convertible securities is because it's so flexible and easy to raise custom amounts of money, you know, you can raise a hundred k and decide that you could bootstrap on that for a while, and then maybe in a couple months, you raise 50 k because you just need a little bit more.

It's very flexible, but you can end up with a ton of investors. And we call that a party round. Right? Used to be that in the old days, you'd maybe have six to 10 investors, and now you can have, you know, 25, 30 five different angel investors who've given you money. That's great. You got the money.

It's not a bad thing, But it can be administratively really challenging because they become stockholders when you do a price round, and then you need their consent because, you know, corporations have stockholder consents. Kinda hard to chase down all those signatures. Again, not a bad thing. Just something you gotta be aware of.

And finally, one of the side effects of these convertible rounds is that investors write smaller checks. They tend to. And they don't care as much about the investor. They're not stockholders yet. So they're not quite as invested. This is a double edged sword. Sometimes investors can drive you insane, But sometimes they can be really helpful. Right?

They will, make introductions for you. They'll help you with strategic advice. So having investors who've just written a check and gotten a convertible security as opposed to writing a really big check and being a stockholder, it can mean the difference between how much attention they pay to you. Again, can be good, can be bad, but it's just a side effect. This is my summary slide. Okay.

So modern early stage rounds of financing are usually done now using convertible securities like the SAFE. Selling preferred stock in priced rounds is still modern. It still happens. It has to happen. It just tends to happen later. It tends to be your second fundraising, not your first. The whole point, as I said before, is focus.

If you don't have to spend a lot of time negotiating documents, if you can get the money in the bank really fast, you can go back to building your company, which is what you want. It's what your investors want. Specifically for this crowd, this is not San Francisco. This is Boston.

Safes and convertible securities are completely common on the West Coast, I suspect that you guys will find angel investors and other people in your ecosystem out here that are less familiar with doing financings this way. So maybe a little bit of education involved. You may have investors who say, no, I don't I've never heard of this SAFE. I want to do a convertible promissory note.

Or you may have investors who are just like, what are you talking about? I don't do convertible securities. I'm buying preferred stock. That's what we're doing if you want my money.

Kind of hard to say outside of the Silicon Valley, but for the most part, I would recommend that you approach fundraising with this idea of doing convertible securities just because it can be done so fast and so flexibly. And that is it.