How to Choose the Right Financial Instrument to Attract Investors
Curated from: entrepreneurshandbook.co
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What is Common Equity?
As a founder, you hold common equity. Your employees, executives, and advisors get common equity (or options to purchase common equity). This is the basic form of stock in a company.Ā
But investors donāt want common equity. They want Preferred Shares which give us rights and protections not included in common equity.
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What is Preferred Equity?
Outside investors typically request/demand conditions such as:
- Liquidity preference: in an exit, we get paid back our investment (or some multiple of it) before common shareholders get any payout
- Board seat or observer rights: we get a representative on the board of directors, or at least the right to attend all board meetings
- Information rights: we get regular financial updates
- Participation rights: we get the right to buy shares in future rounds.
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What is a Convertible Note?
The convertible promissory note is a standard loan document with a special provision: when the company sells stock to other investors, the loan amount is applied to the purchase of the stock.
Legally itās a loan. The paperwork says itās a loan. The accountants put it on the books as a loan. The IRS considers it a loan (a problem weāll get to later). It has a maturity date and an interest rate like a loan. Itās not a loan.
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What is a SAFE?
What investors really want is a simple way to purchase equity now while leaving the docs for later. So the folks at Y-Combinator invented the āSimple Agreement for Future Equityā. The SAFE runs only 7 pages and is not supposed to be modified.
Unlike a convertible note which purports to be a loan, the SAFE states that it is the purchase of equity. While the IRS has not made a ruling, since the SAFE is clearly not a loan, a strong case can be made that it must be equity and therefore eligible for the huge tax benefits of purchasing equity.
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