Carolynn Levy - Modern Startup Funding

I like Kevin said, I'm going to talk about modern startup financing. I have only been practicing law for 21 years, so what's old and what's new only spans that timeframe for me. But I've seen a lot of changes to the startup ecosystem. YC has been a big part of a lot of the changes to the startup ecosystem in 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. This doesn't happen anymore, but I just thought this was, I saves in my mind I thought this was a good picture for this.

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 co-founders 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, but 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 a fraction of a penny. You may contribute some intellectual property as part of that purchase, but basically you're going to be buying your stock and own a hundred percent 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 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 rail note round, safe financing, we're going to talk about what the safe is: early stage around 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. By that, I just mean that the actual document that we use for early stage fundraising has changed, and I'm going to 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 these signatures, 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.

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. Like I don't remember an investor or a founder, "My 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 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 wind 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 them, 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.

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 start-up 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 but I'll stock—that's mostly for a series A financing just be the stuff that the founders owned—and that gets you a price per share. You'd take that price per share and you would sell your preferred stock to your investors. So now, 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 million dollars in your series A preferred stock round. Angel groups now write individual checks; it 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.

There is, you know, there's about five of them. This took months, and it could cost anywhere in legal fees from twenty-five to one hundred thousand dollars. Okay, so what's broken about that? Well, that's pretty elaborate, right? It takes a long time; it costs—I just told you it could cost, you know, twenty-five to 100k in 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.

Gerry's plug in a touch on this. It used that the cost of starting a company has decreased a ton over the years—not so much for software and e-commerce companies, I'm sorry, not so much for hard tech companies—but software, edan, and e-commerce companies, the price of actually starting these startups has way decreased, and as a result companies actually don't need to raise one point five to two million dollars just to get off the ground.

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. Oftentimes, the company would then go to its lead investor—its lead investor rather in the 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 no 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 financing. So again, keep in mind these finance things I just told you were long and expensive, so you weren't just doing them all the time. This is where bridge loan financing came in.

At the heart of the bridge loan was this convertible promissory note. 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 no purchase agreement or the Comstock warrants—but the convertible promissory note itself could actually be used as a standalone 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 this series A financing, instead you just had a convertible promissory note, which was obviously going to be a lot faster. It's only one document used. 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 50k 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. 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. Unlike the promissory note, it is one simple document. It is a convertible security.

So 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 50k and turning it into a billion dollars is everybody—those investors—want to be stockholders and startups don't want to be thinking about accruing interest or you know when is their note gonna 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 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 startup school video lectures that you guys can watch to hear a ton more about the safe. This is the YC page; this is the resources tab. So, say finance and documents at the top, we have a user guide that is kind of long, but it has a ton of really good information and tons of math examples to use to show you how it converts, so please visit that.

Then the safe is only five pages long, has the word simple in it, right? It's actually really easy to read. So then the question is when do priced rounds happen? They are still the primary way that startups raise money. They're no longer the way that most startups raise to do their first fundraising, but builds into the safe and other convertible securities like promissory notes is the whole concept that eventually the company's 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 from Disturbed's cannot convert unless there is a priced round done eventually. So, priced 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 it's kind of laughing at them because they are involved 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 priced round documents you can get them online these days. You still—everyone tends to still hire a lawyer for them, but okay.

So did we perfect modern early stage financing by use it, by introducing a safe, and by you know everybody using convertible securities to raise money the first time? I would say 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 tell how much ownership of your company you have sold when you sell a convertible security.

They're not on your cap table of stockholders, right? You're still a hundred percent 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 got to do the work. There's no excuse for being surprised by realizing you sold 30 percent of your company top to all of your angel investors, so don't let that happen to you.

The other thing that is a little 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 100k and decide that you could bootstrap on that for a while, and then maybe in a couple months, raise 50k 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 ten investors, and now you can have 25, 35 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 challenging because they become stockholders when you do a priced round, and then you need their consent because you know corporations have stockholder consents. Kind of hard to chase down all those signatures—again, not a bad thing, just something you got to be aware of. 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. 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 got into 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 and 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. What 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 finance things 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 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 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. Do you want me to do questions? Ok, how many? A few? Ok, yes. So I do not think—I repeat—the quota's long. Ok, so if you take small checks from angel investors to do your early fundraising, do VCs look at that in a negative light when you go to them to do your priced round?

I would say no, they don't. I mean, you've taken small amounts of money; you've gotten X far, right? Like you've hit all these milestones, and now going to these seasons saying, "Please do my priced round." I think the fact that you raised money from angels and took some small checks just shows how focused you were on getting through that process fast and iterating and getting to the place where you can do a priced round.

Yeah, maybe building a little off a smaller check, but do you ever recommend something like equity crowdfunding? So, like, yeah, so great question. You know, I thought that was super interesting. Just since I've been practicing for 21 years, like that's a huge change, right?

And oh, I'm sorry, yeah, ok, he was running about crowdfunding, so they changed—the SEC changed the rules. You can now actually generally solicit and have your company be crowdfunded where actual strangers can buy your equity. It has a lot of rules and regulations around it. If you like, it's still in the testing phase—like no YC company to my knowledge has done that yet, so I don't have any personal experience with it, Mike died.

But I know some companies have done it, and they would be really interesting to go online and see if you can download from law firms that have helped with those crowdfunding initiatives to see kind of what the pros and cons were. Ok, yeah, so according to the current state, what happens if the company does the following?

Okay, so that's a great question—so he is wondering what happens if you never do a price round; you've sold a bunch of safes to investors. This safe only converts in the event that you raise a price round, your company gets sold, or you go public. And there is absolutely this concept that, well, what if my company just putters along and never needs to raise any more money?

That is what I call a corner case, and my whole point in drafting the safe was to keep it simple. So I specifically did not try to capture every corner case that's out there. It is exceedingly rare for a company to be able to take a tiny amount of money that it raises from its safe holders and then go on and never need to—nothing couldn't happen, but it's pretty rare. There's going to be a liquid—I mean, the founders want liquidity too, right? So how are the founders ever gonna get liquidity if they don't sell or go public or, you know, raise more money?

So yes, of course, and some—you will surely meet some investors who raise that exact point. Well, you know, with promissory notes, at least it was debt. It could be repaid; they knew they were gonna get their money back; that's not true with the safe. But again, it is like—it’s a gamble. It's like, investor, do you want to buy a piece of my company? This is how you can do it.

And if you don't believe that I'm ever gonna raise money again or that I'm ever gonna do anything with this company, then maybe it's not the right investment, you know? So there's a million different ways you can respond to that, but basically in all my years of practice, I only ever had one client that had only raised one round. Like it just—companies need more money to grow; it's kind of the way I look at it.

Way in the back [Music] okay, what's the threshold? From how do you know which convertible security or should you do a price round? How do you know basically what to do? I'm glad you asked that question because I did—I wanted to make this point and forgot. If a VC wants to give you five million dollars as your very first fund raise, do it.

It's like I'm not sitting here saying you should never do a price round for your first fundraising event. Absolutely! So if someone wants you to do a price round and it makes sense for your company: valuation, why's dilution, why's money raising, why's do it? Otherwise, it does not matter how much you're raising on convertible securities; it's about what you're comfortable with, and it's about tracking dilution, right? How much are you actually selling?

We had a YC company that did a 50 million dollar safe, and I almost choked because I was like, I didn't build it for that. You know, it's a very simple document; it made me nervous thinking about it, but it's fine; it worked; it's fine. So it kind of depends on what your investors want to do with you. Again, you need their money, so if they really, really want to do convertible promissory notes and that's how you're gonna get to the next milestone and you need that money, take it, right? It's better than dying.

But, you know, should you not do save just because someone wants to do a five hundred thousand? Do a five hundred thousand dollars if it's fine—just again track the dilution. Yeah, oh, I'm glad you asked that again. This is all in that other lecture, but because you asked, he wanted to know what the key terms of the safe are. Valuation—that's it. That's the only thing you have to negotiate in a safe.

So, and that's probably— I mean, it's not an insignificant thing, right? You and your investor have to decide what valuation you're going to plop into the safe as your target valuation, and that's going to play into the math about how it converts, and that plays into dilution too, so you have to figure that out. And there, we do have a version of the safe. If you go to the resources tab, you can see all these—we do have a version of the safe that doesn't actually even have a valuation in there. So in theory, you could even get away with not even negotiating a valuation with your investors, and you could try it that way.

So then, so that’s an option. But freely, that's the only thing you need to negotiate. And like I said, no lawyers; because what do you need them for? Ok, so this person's investor is saying, "Let’s add something to the safe that will address the issue of what if you never do a price round in my safe never converts."

So sure, if that's the way you can get the money from this person and you really want this person's money and you need to do it, that's fine. You know, with the convertible promissory notes used to do is they would have a term sheet attached to them as an exhibit, and at the maturity date, the company hadn't already gotten a priced round put together with a new lead investor, that money would automatically convert on the terms that were negotiated on that term sheet.

That’s our route I could have taken with the safe, but honestly, that's just more stuff to negotiate, and I didn't want that to be part of the safe, so that's not—but if your investor said, "Let's just put, let's just have this automatic conversion event here are the terms," you can totally do that. Two more questions?

Okay, anyone else? Yes? Okay, so his question was, "What if you wanted to give?" Basically, you're saying, "What if I want to give someone equity for services rendered because I don't want to give them cash?"

Okay, so the safe is a weird instrument to use for that because the safe is fundamentally like, "Give me the money upfront; I'll give you the stock later." If you're not getting any money—if you're saying basically I'm getting my services and I'm just gonna give you stock—I mean, that's probably not the way I would handle it. Better to try to get money.

Yeah, probably. I mean, I don't really think of the safe as being the thing you can use to—what you're talking about is how do I get really cheap founder-like talk to someone who's done a favor for me? And I wouldn't use the safe for that. I think there's other ways you can do that.

And am I allowed to say we're doing an AMA on Friday? Like these kinds of questions, we're gonna do an AMA. Am I actually gonna have my other YC legal team with me, and we can answer questions like that and give you a few more ideas? But probably not the safe for that, just to answer your question. Okay, is anyone—anyone else? We all good? All right. [Applause]