Understanding Your Term Sheet Options
Up until now, our ongoing term sheet series has focused on how to read an equity term sheet and a convertible debt term sheet. But before you learn to read term sheets, you need to know what your financing options are. Specially, as an entrepreneur, what kind of deal structure makes the most sense for your business? Below, find a quick-read overview of three different financing options: convertible notes, safes, and equity. Note that while understanding your options independently is critical to solid decision-making, you should also consult a lawyer with a venture financing specialty before you commit to one type of raise over another.
Convertible Note: At it’s most basic, a convertible note is an investment vehicle structured as a loan that will convert to equity in a future round. The intention of a convertible note is not debt collection, but instead to create a path to equity conversion that comes with some additional benefits to compensate for investor risk. Namely, convertible notes can come with caps or discounts that make them more appealing to investors.
A convertible notes can make sense in the early stages because they are faster and more cost-effective, which may help newer companies with limited cash reserves. A convertible note, however, defer critical decisions, including a major one around valuation, to later rounds. As a result, they are often not used after the early-stages.
Safe: The safe, or simple agreement for future equity, was designed and created by YCombinator as an alternative to convertible notes. Unlike a convertible note, a safe is not a loan and therefore does not collect interest or have a maturity date. There are fewer terms in a safe since there are no maturity dates or interest rates to negotiate. As a result, the main term up for negotiation is the valuation cap.
The safe is best used in the earliest stages because it does not address some of the most critical terms, including valuation, liquidation preferences, and participation rights. Instead, it defers conversations and negotiations around those terms to the next round. The safe, since it does not have a maturity date, does not account for circumstances when a company succeeds but does not have a liquidity event.
Equity: Even if you decide that a convertible note or safe makes sense for you, if your business continues to seek future rounds of capital, you will eventually end up in an equity round. Basically, when you enter into an equity agreement, you are agreeing to give up a certain percentage of ownership of your company in exchange for investment. The details of how much ownership you give up and for what price are part of negotiations and represented in a cap table.
An equity term sheet will inherently be more complex than the kinds you would encounter in the first two examples since they defer many key terms to this phase. While there are many important terms you’ll negotiate in this transference of funds for ownership, the three most important will bevaluation, liquidation preference, and board composition.
There are advantages and disadvantages to all three financing options. However, it’s important to remember that safes and convertible notes make more sense in the very early stages and that both are working with the assumption that you will be raising an equity round in the future.
Alida graduated Phi Beta Kappa from the University of Chicago in 2014 with multiple honors and awards. She remains active in the university of alumni network, serving on five advisory boards and committees. Alida is also a published author and poet, with two poetry chapbooks currently in print,Domestic Scenes and Tree Fingers.