Choosing Between Financing Instruments for Your Startup
Choosing the right financing instruments early on impacts not only how your cap table evolves, but also your ability to attract subsequent investors and navigate regulatory compliance. The stage that your company is in will play a critical role in the determination of which types of fundraising instruments are most appropriate to use. This article aims to explain the distinctive features of each type of financing instrument to help you chart your course.
Investments can be in the form of debt, equity or convertible financing instruments, and most startups utilize a mix of these to fund their companies. Startups also use non-dilutive funding instruments such as grants, awards and customer financing, covered briefly in this post. Investors with differing levels of sophistication and risk-aversion will seek financing instruments and terms that suit their interests and risk tolerance. Founders should have a clear understanding of the key terms associated with each instrument, along with the potential implications for ownership, control and future fundraising activities.
Financing Instruments for Early-Stage Startups
Early-stage startups often use equity and convertible financing instruments with their early investors. A report analyzing over 9,000 pre-seed companies on Carta found that over 90% of pre-seed rounds in Q4 2024 were raised on SAFEs, while 9% were raised using convertible notes. Convertible notes are also commonly used for bridge financings between preferred stock financing rounds. In contrast, equity financings (Series Seed, Series A, etc.) and other forms of investments (i.e., debt facilities) most often come later in the startup’s lifecycle when a company’s financial performance is able to support it and there is enough history for firms to be able to underwrite it.
Financing Instruments for Later-Stage Startups
Founders who are concerned about the dilution of shares can consider sources of non-dilutive funding; however, these types of funding are usually only available to companies that are past the series-seed stage. This is because many non-dilutive funding sources require companies to demonstrate proof of concept, a plan for revenue, or backing from large institutional investors, which early-stage startups often lack. Examples of non-dilutive funding include grants, product-based crowdfunding (i.e., Kickstarter), venture debt and working capital facilities.
Choosing the Right Instrument
For early-stage startups, SAFEs and convertible notes offer speed and simplicity, though they come with tradeoffs like potential dilution and deferred valuation discussions. As a company matures, transitioning to equity financing or considering non-dilutive sources like grants or venture debt may be more appropriate.
Choosing the right financing instrument for each investor is crucial in the early stages of funding your company. When making these choices, be sure to consider the impacts of future dilution, the pros and cons of valuing the company, and the company’s need for capital to hit milestones and valuation inflection points. A funding strategy that is aligned with both the company’s goals and investor expectations can position your startup for sustained success while preserving room for future fundraising rounds. Lastly, market forces place a large role in determining the financing strategies most likely to succeed. Consult with advisors that have a good read on the current financing environment to understand what paths are likely available.
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Investments can be in the form of debt, equity or convertible financing instruments, and most startups utilize a mix of these to fund their companies. Startups also use non-dilutive funding instruments such as grants, awards and customer financing, covered briefly in this post. Investors with differing levels of sophistication and risk-aversion will seek financing instruments and terms that suit their interests and risk tolerance. Founders should have a clear understanding of the key terms associated with each instrument, along with the potential implications for ownership, control and future fundraising activities.
Financing Instruments for Early-Stage Startups
Early-stage startups often use equity and convertible financing instruments with their early investors. A report analyzing over 9,000 pre-seed companies on Carta found that over 90% of pre-seed rounds in Q4 2024 were raised on SAFEs, while 9% were raised using convertible notes. Convertible notes are also commonly used for bridge financings between preferred stock financing rounds. In contrast, equity financings (Series Seed, Series A, etc.) and other forms of investments (i.e., debt facilities) most often come later in the startup’s lifecycle when a company’s financial performance is able to support it and there is enough history for firms to be able to underwrite it.
Convertible Notes
Convertible notes are a common form of convertible financing instrument. These financing instruments are initially structured as debt but have the potential to convert into equity upon a specified triggering event, typically the next priced equity round (i.e., a Qualified Financing) and sometimes at maturity or with mutual consent.
Convertible notes accrue interest and have a maturity date where the loan becomes due on demand if the triggering event has not occurred. Convertible notes often come with additional terms including discount rates, which give the noteholders a discounted price when their note converts to equity, and/or valuation caps, which set the enterprise value at which the notes will convert even if the value of the company’s stock increases. Additionally, many convertible notes include a premium if repaid in connection with a change of control (typically ranging from 50% to 300%).
SAFEs (Simple Agreements for Future Equity)
Like convertible notes, Simple Agreements for Future Equity (SAFEs) are designed to convert to equity when a triggering event occurs (i.e. the next preferred stock financing round). Unlike convertible notes, however, there are no debt components of a SAFE, which means there is no interest accrued or a maturity/repayment date. In the case of a SAFE, if the conversion event does not occur, the company has no obligation to repay the SAFE holders until there is a change of control.
SAFEs are usually 2–3-page documents based on the form created by startup accelerator Y Combinator. SAFEs are administratively simple and cost-effective to execute, and in some scenarios, the form can be tailored to fit the interests of the investors and the company.
Like convertible notes, SAFEs can have a valuation cap, conversion discount (%), or both. SAFEs can also be structured to grant holders pro rata rights and specify whether the investor’s ownership percentage will be based on the company’s pre-money or post-money valuation.
As for the risk of dilution, the conversion price of a pre-money SAFE is calculated based on the company’s valuation before the SAFE investment, meaning that the ownership percentage of investors is uncertain and can be impacted if other SAFEs are issued later on. In contrast, a post-money SAFE establishes a fixed percentage ownership among the convertible notes and other SAFEs, increasing dilution on existing equityholders.
Equity
In an equity financing round, investors are granted stock (preferred stock in most circumstances) in exchange for their investment in the company. In exchange for being early contributors, early-stage investors may request specific benefits including, but not limited to, reserved board seats, pro rata rights, liquidation preferences and anti-dilution rights. These rights enable investors to better mitigate risk and preserve their ownership stake in the company.
Equity financings require the execution of numerous documents, including negotiating a term sheet and drafting financing documents (see NVCA model documents) as well as amending the Company’s certificate of incorporation and passing board and stockholder resolutions. While this funding source may be costly to execute, it has the benefit of supplying early-stage companies with capital that it will not need to pay back.
When a company issues new shares to investors in exchange for capital, the ownership percentage of existing shareholders is reduced unless they participate in the financing round or have anti-dilution protections in place. This dilution affects not only founders but also earlier investors and employees holding stock options. (The sale of common stock is less common for startups for several reasons and is not covered in this post.)
Convertible notes are a common form of convertible financing instrument. These financing instruments are initially structured as debt but have the potential to convert into equity upon a specified triggering event, typically the next priced equity round (i.e., a Qualified Financing) and sometimes at maturity or with mutual consent.
Convertible notes accrue interest and have a maturity date where the loan becomes due on demand if the triggering event has not occurred. Convertible notes often come with additional terms including discount rates, which give the noteholders a discounted price when their note converts to equity, and/or valuation caps, which set the enterprise value at which the notes will convert even if the value of the company’s stock increases. Additionally, many convertible notes include a premium if repaid in connection with a change of control (typically ranging from 50% to 300%).
SAFEs (Simple Agreements for Future Equity)
Like convertible notes, Simple Agreements for Future Equity (SAFEs) are designed to convert to equity when a triggering event occurs (i.e. the next preferred stock financing round). Unlike convertible notes, however, there are no debt components of a SAFE, which means there is no interest accrued or a maturity/repayment date. In the case of a SAFE, if the conversion event does not occur, the company has no obligation to repay the SAFE holders until there is a change of control.
SAFEs are usually 2–3-page documents based on the form created by startup accelerator Y Combinator. SAFEs are administratively simple and cost-effective to execute, and in some scenarios, the form can be tailored to fit the interests of the investors and the company.
Like convertible notes, SAFEs can have a valuation cap, conversion discount (%), or both. SAFEs can also be structured to grant holders pro rata rights and specify whether the investor’s ownership percentage will be based on the company’s pre-money or post-money valuation.
As for the risk of dilution, the conversion price of a pre-money SAFE is calculated based on the company’s valuation before the SAFE investment, meaning that the ownership percentage of investors is uncertain and can be impacted if other SAFEs are issued later on. In contrast, a post-money SAFE establishes a fixed percentage ownership among the convertible notes and other SAFEs, increasing dilution on existing equityholders.
Equity
In an equity financing round, investors are granted stock (preferred stock in most circumstances) in exchange for their investment in the company. In exchange for being early contributors, early-stage investors may request specific benefits including, but not limited to, reserved board seats, pro rata rights, liquidation preferences and anti-dilution rights. These rights enable investors to better mitigate risk and preserve their ownership stake in the company.
Equity financings require the execution of numerous documents, including negotiating a term sheet and drafting financing documents (see NVCA model documents) as well as amending the Company’s certificate of incorporation and passing board and stockholder resolutions. While this funding source may be costly to execute, it has the benefit of supplying early-stage companies with capital that it will not need to pay back.
When a company issues new shares to investors in exchange for capital, the ownership percentage of existing shareholders is reduced unless they participate in the financing round or have anti-dilution protections in place. This dilution affects not only founders but also earlier investors and employees holding stock options. (The sale of common stock is less common for startups for several reasons and is not covered in this post.)
Financing Instruments for Later-Stage Startups
Founders who are concerned about the dilution of shares can consider sources of non-dilutive funding; however, these types of funding are usually only available to companies that are past the series-seed stage. This is because many non-dilutive funding sources require companies to demonstrate proof of concept, a plan for revenue, or backing from large institutional investors, which early-stage startups often lack. Examples of non-dilutive funding include grants, product-based crowdfunding (i.e., Kickstarter), venture debt and working capital facilities.
Grants
While highly desirable and non-dilutive, grants often come with compliance requirements, including reporting obligations and use-of-funds restrictions. Grant sources include government grant programs, such as the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs, corporate and foundation grants, university grants, and accelerator-affiliated grants.
Crowdfunding
Founders can also utilize donation or rewards-based crowdfunding to source funds outside of traditional debt or equity sources. Crowdfunding websites charge a platform fee in exchange for facilitating funding from a wide pool of supporters. Rather than giving these supporters interest payments or shares in the company, founders can reward crowdfunding participants with other such benefits, including early access to products, branded merchandise and recognition.
Venture Debt
Like traditional debt, venture debt is a loan that requires repayment and will not result in the dilution of shares (except for issuance of warrants in connection with the debt). The lenders that offer venture debt tend to specialize in startup lending, and as such, understand the risk associated with lending to them. Given the higher risk profile of startups, venture debt typically carries slightly higher interest rates than traditional loans and may include warrants for the lender. Lenders are more willing to loan to startups that are already backed by venture capitalists and have established predictable revenue streams.
Founders should keep in mind that venture lenders often require collateral and may impose financial covenants which can include financial reporting requirements, deposit account control agreements (DACAs), restrictions on acquiring additional debt, and maintaining a certain threshold of liquidity.
While highly desirable and non-dilutive, grants often come with compliance requirements, including reporting obligations and use-of-funds restrictions. Grant sources include government grant programs, such as the Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs, corporate and foundation grants, university grants, and accelerator-affiliated grants.
Crowdfunding
Founders can also utilize donation or rewards-based crowdfunding to source funds outside of traditional debt or equity sources. Crowdfunding websites charge a platform fee in exchange for facilitating funding from a wide pool of supporters. Rather than giving these supporters interest payments or shares in the company, founders can reward crowdfunding participants with other such benefits, including early access to products, branded merchandise and recognition.
Venture Debt
Like traditional debt, venture debt is a loan that requires repayment and will not result in the dilution of shares (except for issuance of warrants in connection with the debt). The lenders that offer venture debt tend to specialize in startup lending, and as such, understand the risk associated with lending to them. Given the higher risk profile of startups, venture debt typically carries slightly higher interest rates than traditional loans and may include warrants for the lender. Lenders are more willing to loan to startups that are already backed by venture capitalists and have established predictable revenue streams.
Founders should keep in mind that venture lenders often require collateral and may impose financial covenants which can include financial reporting requirements, deposit account control agreements (DACAs), restrictions on acquiring additional debt, and maintaining a certain threshold of liquidity.
Choosing the Right Instrument
For early-stage startups, SAFEs and convertible notes offer speed and simplicity, though they come with tradeoffs like potential dilution and deferred valuation discussions. As a company matures, transitioning to equity financing or considering non-dilutive sources like grants or venture debt may be more appropriate.
Choosing the right financing instrument for each investor is crucial in the early stages of funding your company. When making these choices, be sure to consider the impacts of future dilution, the pros and cons of valuing the company, and the company’s need for capital to hit milestones and valuation inflection points. A funding strategy that is aligned with both the company’s goals and investor expectations can position your startup for sustained success while preserving room for future fundraising rounds. Lastly, market forces place a large role in determining the financing strategies most likely to succeed. Consult with advisors that have a good read on the current financing environment to understand what paths are likely available.