Raising money for a start-up can take many different forms - but things are a bit tough when your company is still just a start-up and in its initial stages. One way is to use convertible instruments such as convertible notes, SAFEs, and KISSs. When using a convertible, the start-up receives the investment but does not issue shares at that stage. The agreement can ‘convert’ into shares in the future, hence the name. This so-called “conversion” happens upon the occurrence of a specific event, such as an equity funding round or an IPO.

What are Convertible Securities?

Have you heard of convertible securities? They're actually pretty cool. Essentially, these are securities that can be converted into common stock. They're often bonds or preferred shares that allow bondholders to convert their creditor position to that of an equity holder at an agreed-upon price. Convertible securities can come in all shapes and sizes. 

A while back, convertible notes were introduced, and they were complex, expensive, and took a long time to finalize due to negotiations. But then came the KISS and SAFE instruments, which were designed to make things easier for companies to make deals and get funding faster. They're relatively new, but they've become quite popular among start-ups due to their simplicity and ease of use. Just keep in mind that both instruments are unique and choosing between them depends on the specific needs and goals of the start-up and the investor.

Benefits of Using Convertibles

Here are the benefits of using convertible instruments such as convertible notes, SAFEs, and KISSs:

Quick access to capital without having to issue shares. Convertible instruments allow start-ups to access capital quickly without having to issue shares because the start-up receives the investment but does not issue shares at that stage.

Flexibility in choice of valuation. Convertible instruments offer flexibility in choosing between pre-money or post-money valuation. As a result, the start-up valuation can be either pre-money or post-money.

Quicker and less expensive than traditional equity funding rounds. Convertible instruments are usually quicker and cheaper than conventional equity funding rounds because it is a more straightforward process with fewer terms and conditions.

A more straightforward process with fewer terms and conditions. Convertible instruments are a more straightforward process with fewer terms and conditions, making it easier for start-ups to raise capital without going through the complex process of traditional equity funding rounds.

While the benefits of convertibles are apparent, the more difficult question is which type of convertible to use. It is important to remember that the final decision between these instruments depends on the specific needs and goals of the founder and investor and that’s what we would discuss in the next section. 

Y COMBINATOR’S SAFE AND 500 STARTUPS KISS

I’m sure by now, you might have heard about the SAFE convertible instrument and KISS convertible notes. 

These are two sets of model legal documents that can make your life a lot easier. The SAFE was developed by Y Combinator, while the KISS was developed by 500 Startups. You can easily download both sets of documents for free, which is great because it simplifies and standardizes the process of obtaining seed financing.

Traditionally, convertible promissory notes and priced equity were the two mechanisms used for raising seed capital. But SAFE and KISS notes are becoming increasingly popular alternatives. Both of these are convertible securities, which means that investors provide cash today with the intent to convert to equity upon the occurrence of some future event.

Now, if you're planning to issue a SAFE convertible instrument or KISS convertible notes, it's important to know the basic terms that make the deal, as explained below. 

Common Terms Used in Convertible Notes 

1. Discounts

The discount is the first term of any convertible security. It's the difference between the conversion price and the price paid by the new investors at the subsequent priced round.  For example, if a convertible note has a 20% discount and the startup raises Series A at $10 per share, you will convert your debt into equity at $8 per share.

2. Valuation caps

To protect yourself from dilution, you might want to look for convertible notes with a valuation cap. This means that there is a maximum valuation at which the investor can gets its note converted to equity. For example, if a convertible note has a $3M valuation cap and the startup raises Series A at a $5M valuation, you will convert your debt into equity at a $3M valuation and get a higher ownership stake in the company.

3. Interest

Keep in mind that convertible notes also accrue interest over time. The interest rate is usually annual, and the interest is added to the principal amount of the debt and converted into equity along with it. For example, if a convertible note has a 5% interest rate and a $100K principal amount, after one year it will accrue $5K of interest and convert into equity at a total of $105K.

 4. Most Favoured Nation

Another thing to consider is the most favoured nation (MFN) clause. This allows you to benefit from any more favorable terms that are offered to other convertible investors in the future. For example, if a startup issues another convertible note with a lower discount or a lower valuation cap, the MFN clause will allow you to adjust your terms accordingly and get a better deal.

Final Showdown: SAFE vs. KISS 

Conclusion 

Convertible instruments such as convertible notes, SAFEs, and KISSs are popular among start-ups due to their simplicity and ease of use.  When a start-up receives investment through convertible instruments such as convertible notes, SAFEs, and KISSs, it does not issue shares at that stage. Instead, the agreement can 'convert' into shares in the future, hence the name. 

In conclusion, these convertible securities can be an excellent option for start-ups looking to raise money, as they offer flexibility and can be tailored to meet specific needs and goals.

 

 

Sources:

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