How to Raise Seed Funding for Your Startup: Convertible Notes and SAFEs

How to Raise Seed Funding
for your Startup: Convertible
Notes and SAFEs
Alidad Vakili, Foley & Lardner LLP
August 17, 2023
Silicon Valley: Idea to IPO
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DISCLOSURE
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presenter or Foley & Lardner. Specific legal issues should be addressed through
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materials. Attorney Advertising. Prior results do not guarantee a similar outcome.
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AGENDA
 Overview
 Structural Considerations
 Documentation for Founders and Early Personnel
 Financing Options
 Convertible Securities
 Foundational Basics
 Overview to Seed Financings
 Closing Your Seed Financing
 Common Pitfalls
 Q&A
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BACKGROUND
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 Corporate attorney with a practice focus on Emerging
Growth and Venture Capital.
 I work out of our San Francisco office and have worked
with companies throughout the US and the world.
 I enjoy working with and helping entrepreneurs on
startup adventures from startup to liquidity.
Alidad Vakili
Of Counsel
+1.415.438.6421
avakili@foley.com

Foley & Lardner LLP
Preparation is the key to success
“There are no secrets to success. It is the result of preparation,
hard work and learning from failure.
~Colin Powell
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OVERVIEW

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STRUCTURAL CONSIDERATIONS
Key Issues
 Entity type (C corporation)
 Jurisdiction (Delaware)
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DOCUMENTATION FOR FOUNDERS AND
EARLY PERSONNEL
Proper Documentation is Key
 Confidentiality
 Intellectual Property Assignments
 Vesting of Securities
• Stock Options
• Restricted Stock
 Transfer Restrictions
• Shareholder Agreements
• Restrictions in Bylaws
• Stock Purchase Agreements
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FINANCING OPTIONS
 Convertible Debt
• Convertible notes (also sometimes referred to as bridge notes)
 Convertible Equity
• SAFEs (Simple Agreement for Future Equity)
• KISS (Keep It Simple Security)
 Equity / (priced equity or venture rounds)
• Common stock
• Series Seed, Series A, Series B ...
Note: There are other financing options that are beyond the scope of this presentation (e.g., grants,
loans, etc.)
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CONVERTIBLE SECURITIES
 Convert to future equity securities upon a qualified equity financing
• Pros:
• Avoids valuing the company
• Easier to document and less expensive
• Easier and quicker process
• Cons:
• Convertible notes are debt and may be required to be paid at some point
• Convertible notes have extra liquidation preference above all other equity, unless
otherwise handled (i.e., creditors get paid first)
• Conversions can be confusing
• Can result in sweetheart deals (for the investors)
• Less protections for investor
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CONVERTIBLE SECURITIES
 Mandatory conversion at a discount of price paid in Next Qualified
Financing
• Series Seed/Series A needs to meet the definition of a “Qualified Financing”
• Equity financing
• Minimum size, e.g., “$2,000,000”
• Discount should be reasonable. 20-25% is typical.
• Conversion Price Cap (valuation cap)
• Conversion upon a change of control/sale
• Conversion at maturity (for convertible notes)
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CONVERTIBLE NOTES
 Maturity Date
 Interest Rate
 Valuation Cap
 Discount
 Conversion Terms
• Automatic conversion
• Maturity conversion
 Secured vs. Unsecured
 Default
 Representations and warranties
 Amendment Terms, e.g., majority in interest
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SAFES
 Simple Agreement for Future Equity
 Introduced by Y Combinator in 2013 as an alternative to the convertible
note (several types):
• Pre-money valuation cap only (generally more founder-friendly) - less common
• Post-money valuation cap only (generally more investor-friendly)
• Discount rate only
• Post-money valuation cap and discount
• MFN only
 Viewed as investor-friendly
• Simple form
• Cost effective
• Not treated as “debt” on company balance sheet (avoid repayment obligation)
• Gives founders more control of capital
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SAFES
 Valuation Cap
• Pre-money (less common now)
• Post-money
 Discount Rate
 MFN (most favored nations provision)
 Conversion Terms
 Representations and warranties
 Pro rata rights (usually included in a separate (side letter) agreement
 Other rights (major investor, info/inspection, etc.)
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KISSES
 Keep It Simple Security
 Introduced by 500 Startups as an alternative to the convertible notes and
the Y Combinator SAFE:
• Similar to the SAFE
• Valuation cap
• Discount rate
• MFN only
 Viewed as investor-friendly
• Simple and cost effective
• Gives founders more control of capital
Note: Don’t see it being used – the SAFE is much more common
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FOUNDATIONAL BASICS
 To Give or Not to Give?
• Striking the right balance when allocating equity
• Capitalization
• Think backwards when planning
• Ownership
• Control
• Dilution (plan for it – it’ll happen)
• Incentivize your team
• Proper documentation
• Vesting
• Repurchase rights
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FOUNDATIONAL BASICS
 Pre-money valuation – the value of the company before the next round of
investment.
 Post-money valuation – the value of the company after the round of
investment.
 Issued and outstanding basis – all stock issued and outstanding.
 Fully-diluted basis – all stock issued and outstanding, plus all securities
that can be converted to common, plus (typically) the shares reserved for
equity compensation.
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FOUNDATIONAL BASICS
 Very Simple Example (not factoring in the option pool or any other equity)
• Pre-money $10,000,000
• 10,000,000 shares split among three equal founders
• Founder A = 3,333,333 shares or 33%
 Investment $3,000,000 at $1.00/share ($10,000,000 pre-
money/10,000,000 outstanding shares) (post-money is $13,000,000)
 Founder A = 3,333,333 of ~25% with a paper value of $3,333,333
(3,333,333/$13,000,000=25.64%)
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FOUNDATIONAL BASICS
 Basic Examples with Convertible Securities
• If there had been a $450,000 convertible security with 25% discount only,
holder would have received 600,000 shares. $450,000/((1-.25)*$1.00/share)
• If there had been a $450,000 convertible security with $5MM cap only, holder
would have received 900,000 shares. $450,000/($5,000,000 valuation
cap/$10,000,000 pre-money*$1.00/share)
• If there had been a $450,000 convertible security with both a $5MM cap and a
25% discount, holder would have received 900,000 shares, because the
valuation cap results in more shares. $450,000/($5,000,000 valuation
cap/$10,000,000 pre-money*$1.00/share)
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OVERVIEW OF SEED FINANCINGS
 Have a credible business plan with milestones
• Perfect your pitch
 Run a Systematic Process
• Know how much capital you need
• Connect with the right investors
• Understand your ideal term sheet
• Prepare for diligence
• Have good corporate hygiene
• Be prepared for cleanup
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Understand the terms:
 Purchase Amount
 Valuation Cap
 Discount
 MFN
 Equity Financing
 Conversion terms
 Liquidity Event
 Dissolution Event
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 Representations and Warranties
 Pro Rata Agreement (aka Side Letter)

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 Term Sheet
 Diligence process
 Documentation Process
• Safes - Y Combinator - https://www.ycombinator.com/
• Convertible Notes - Proprietary forms
 Pre-Closing
 Closing
 Post-Closing Items
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CLOSING YOUR SEED FINANCING
 ABC (Always Be Closing)
 Do your homework
 Get your Company’s house in order
BEFORE you talk to investors
• Cap table
• Proforma
• Data room
 Do your own diligence on potential
investors
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 Prepare for your closing from Day
1
 Create your team (internal and
external)
 Set a reasonable timeline
 Organize and divide tasks
appropriately

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 Not structuring the entity properly (type
of entity, jurisdiction)
 Not having proper documentation for
founders, employees, consultants
 Failure to own the technology/IP that is
critical to the business
 Not having proper vesting for equity
grants
 Undocumented stakes in the company
 Non-Compliance with Securities Laws
 Not managing the company’s cap table
COMMON PITFALLS
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 Not understanding the terms of the
Safe, KISS, or convertible notes
 Thinking that there are “standard” or
“boilerplate” terms
 Side Letters
 Failure to obtain proper corporate
authorization
 Risk of employment-law issues
 Tax issues – e.g., federal, state, local

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PARTING THOUGHTS…
Do your homework
Prepare in advance
Dream backwards
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Q&A
Alidad Vakili
avakili@foley.com
August 22, 2023
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How to Raise Seed Funding for Your Startup: Convertible Notes and SAFEs

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