# Modern startup funding

**Author:** Carolynn Levy
**Type:** Video
**URL:** https://www.ycombinator.com/library/8F-modern-startup-funding
**YouTube ID:** 9qWZALyGSmg

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YC’s Carolynn Levy details the basics of startup financing and how modern early stage rounds of financing are done using
convertible securities, like the SAFE.

## Transcript

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 a lot 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 you're a 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 and so 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 so a lot of you are gonna 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 gonna 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 or 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 a common stock for 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 its fundraising by selling preferred stock at a calculated specific price per share these terms convertible rail note round safe financing we're gonna 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 coma 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 and 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 and 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 raised their first do their first fund raising 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 as 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

I Lucien 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 gonna 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 so 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

bull back then angel investors you 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 roan angel groups now a right individual checks 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 and there is you know there's about five of them this took months and it was 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 takes a long time it costs I just told you it could cost you know twenty-five to 100k on 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 ecommerce 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 and having to do these long elaborate expensive financings was not worth it so it would

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 be financing sometimes it would run out of money in between and so oftentimes the company would then go to its lead finance that's 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 aren't just doing them all the time and this is where bridge loan financing came in at the heart of the of the bridge alone was this convertible promissory note and 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 in your Series B your convertible promissory notes would convert into shares of series be 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 your 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 alone so it's debt 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 that 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 peace all the debt part out of convertible promissory notes but retain all of the 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 the this is the 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 it 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 they're 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 price round so most often companies will do their first fundraising on a safe convertible promissory note and then they will do a price surround afterward and all of those safes and convertible promissory notes will convert into stock safes in convertible from Disturbed's cannot convert unless there is a price run done eventually so so price 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 price round documents you can get them online these days you still everyone tends to still hire a lawyer for them but ok so did we perfect modern early stage financing by

use it by by introducing a safe and by you know everybody using convertible securities to raise money the first time and 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 stock holders you actually don't it's very hard to tell how much ownership of your company you have sold when you saw a sell a

convertible security they're not 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 price round and they all 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 so don't let that happen to you the other thing that

has that is a little to be aware of with early-stage fund raising 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 to 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 you know

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 administrative leery aliy challenging because they become stockholders when you do a price 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 and 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 is 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 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 the 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 quotas long ok so if you take small checks from angel investors to do your early

fundraising do VC's look at that in a negative light when you go to them to do your priced round I would say no that is they don't I mean you've you you've taken small amounts of money you've gotten X far right like you've hit all these milestones or now go into these season saying please do my priced round I think the fact that you raise 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 price 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 and 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 you can now actually generally solicit and have your company

be crowd funded 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 get like like download from law firms that have helped with those crowdfunding

initiatives to see kind of what the pros and cons were okay yeah so according to the current state what happens if the company does the following okay so that's a great question so so he is wondering what happens if you never do a price around you've ich 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 being 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 and some you 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 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 that's 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 around how do you know basically what your 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 like 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 I didn't build it for that you know it's a very simple document

like 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 like 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 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 place 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 okay

so so this person's investor is saying let's add something to the safe that 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 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 do 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 going to give you stuff I mean I probably that's probably not the way I would handle it better to try to get money

yeah probably I mean it yeah I don't really think of the safe as being the thing you can use to me like what you're talking about is how do I get really cheap founder likes 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 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 little few more ideas but probably not the safe for that just to answer your question okay it's anyone anyone else we all good all right [Applause] you
