The Gust Launch Convertible Stack: New Instruments for Modern Early-Stage Fundraising

Ryan Kutter , ESQ., PRODUCT MANAGER , GUST INC.

3 Oct 2018

Over the past two decades, early-stage startups have increasingly relied on capital from pre-professional investment sources to grow their companies to the stage at which professional investors feel comfortable buying in. Early-stage valuations are rising—but angel and seed-level investors are making fewer investments overall¹, even if those investments are larger.² These trends appear to be connected to the increased popularity of SAFEs and other high-resolution investment vehicles that make it easy for less-sophisticated investors to contribute capital, but also tend to introduce complex equity dilution and increase the difficulty of due diligence for professional investors.

Startups need pre-professional fundraising support, but also need to remain viable investments for professional investors. Gust Launch is providing support and addressing potential challenges by introducing a cohesive set of interconnected convertible instruments that allow startups to raise money from “friends and family” sources without damaging their chances (or their equity stakes) when they are ready for professional investment.

Investment instruments fit for modern early-stage startup financing

Now more than ever, startups have to show traction and progress in their earliest stages in order to entice professional or semi-professional investors—but the needs and investment appetites of funds and syndicated angel groups, while being directionally aligned with friends and family investors, differ greatly in the investment terms they prefer when negotiating with startups. Friends and family investors are primarily interested in supporting the founder. Meanwhile, angel groups and seed funds take a more professional approach to their investments, as they are primarily interested in making a high return on their investment. Thus, they require more control, protections, and specificity in their investment structures.

The friends and family population has been well-served in many ways by the introduction of the Simple Agreement for Future Equity (SAFE) in 2013. The SAFE was designed by Y Combinator to simplify and replace the convertible note, a more traditional debt-based early-stage investment mechanism. SAFEs, along with other instruments like 500 Startups’ KISS, have facilitated startups’ ability to collect money from less-sophisticated investors, and they’ve come to represent up to 14% of the entire early-stage market, especially in Silicon Valley³—but at costs that are only now becoming increasingly apparent.

In particular, SAFEs’ ease of creation and simple terms have led founders to raise money on multiple layers of SAFEs that have varying conversion terms. This practice is commonly known as “note stacking.” But multiple convertible instruments acting in unison, all with the same qualified financing event (the future preferred stock round), can create a lot of equity overhang for the convertible instrument holders. This overhang causes founders to end up with much less equity after the qualified financing than they may have expected and can also lead to professional investors passing on investing, since the complexity and interplay of the stacked notes changes the economics of the deal.

By using a SAFE with properly considered terms, a startup can avoid these unintended side effects. The SAFE that Gust Launch is introducing today is built around those terms.

With the increasing challenge for many new startups to secure funding, it is becoming more important that founders have the tools and strategies to successfully grow their businesses, even beyond early financing instruments. Most angel and seed funds only invest in Delaware C-Corporations, and will perform fairly substantial due-diligence to validate the business model and assess the risk of the deal. To meet today’s degree of difficulty for securing investment, startups need to optimize both their company and financing strategy.

Gust Launch has been working toward the goal of standardizing startups for professional investment in terms of their corporate structure for almost two years, and with that in mind, here’s how we are now taking steps toward supporting standardized startup fundraising.

The Gust Launch SAFE

When it was introduced, the SAFE offered a simplified and standardized approach to investment terms in order to reduce transaction costs and more easily raise early-stage money. The simplicity of the agreement is particularly useful for friends and family rounds—it allows an investor that doesn’t want to negotiate the various terms of a convertible note to invest in a company without much in the way of transaction costs. In addition, seed investors sometimes use SAFEs to make a relatively small “placeholder” investment in a very hot startup (think: the 1% of the 1% of startups) where the likelihood of raising a preferred stock round is almost assured. The SAFE allows the seed investors to secure a future equity position in the startup, while leaving traditional investor protections until they make a much larger investment at the expected future preferred stock round. In either use case, the startup generally raises less capital using the SAFE than it would from professional angel investors—typically less than $200K.

The Gust Launch SAFE is based on the original Y Combinator template for typical friends and family rounds: a 20% discount on the next valuation with no valuation cap. To make the basic SAFE more practical and founder-friendly for cases where there are additional funding rounds before a large preferred stock financing, Gust Launch SAFEs introduce a concept we call a “rollup,” designed to combat founder dilution. If a startup issues a Gust Launch SAFE and subsequently issues a convertible note to more sophisticated investors, the principal investment of the SAFE will transfer to the convertible note round at the same, more advantageous terms as the other convertible note holders. The SAFE investors will then become convertible debt holders, just like the professional investors. On the other hand, if the startup does not issue a convertible note before its first preferred stock round, the SAFE’s investors will still convert their stakes to preferred shares at a 20% discount.

In keeping with the original purpose of SAFEs, earliest-stage investors (friends, family, and angels) can invest in the startup easily and simply, keep transaction costs low, and benefit from the discount on preferred stock in a future round. Unlike the standard SAFE, Gust Launch SAFEs protect the founders from the unintended equity overhang and reduce the dilution effects that a convertible waterfall may cause.

Here’s how a Gust Launch SAFE works:

• There is no valuation cap. This is because at the very earliest stages of a company’s life, when a founder is raising a relatively small amount of funding from inexperienced investors, there is a high risk that any cap will be either inappropriate or unfair to one party or the other. If investors insist on a valuation cap, they are also likely to insist on the many protections that professional early stage investors require. The company should consider using the Gust Launch Convertible Note instead.
• The discount rate is set at 20%. This is overwhelmingly the industry-standard discount rate for convertible agreements.
• Each investor must be accredited as defined within Regulation D of the Securities Act.⁴
• Upon the issuance of a subsequent convertible note, the SAFE’s investors will be converted to holders of the same convertible note, subject to all the same, more advantageous, terms as the holders of that note—avoiding undesired founder dilution.

To ensure that the rollup benefit will work, it is essential that all the company’s SAFEs be issued through Gust Launch. If only some of a company’s SAFEs allow rollup, rollup can’t mitigate the note stacking effect as designed, especially if the startup conducts a convertible note round before its first preferred stock raise.

The Gust Launch Convertible Note

Before SAFEs, convertible notes were the default early-stage investment vehicle: angel groups and seed funds relied on convertible notes to avoid the cost and complexity of executing a preferred stock round while still providing themselves the benefits of equity ownership in the future.⁵ A convertible note is a debt instrument, with interest and repayment schedules incorporated into the agreement. Unlike a typical loan, however, a convertible note is always intended by both parties to convert into preferred stock in the near future.

Convertibles notes still offer many advantages to early-stage investors, so even as SAFEs and other alternative instruments grow in popularity for informal early investments, convertible notes still dominate professional seed-stage investments. Along with specifying a discount and a valuation cap equal to the current valuation of the company, convertible notes provide investors preferential rights and terms that protect their investment and ensure that the economics of the deal make sense in spite of the financial risk that comes along with very early investments. The discount, similarly to the discount on a SAFE, allows the note principal to translate into a larger stake than it could typically buy during a future preferred stock raise, but the valuation cap, which is set at the current valuation the investor believes the company is worth, establishes a ceiling for the highest valuation that the note will convert. This guarantees the convertible note holders a reward for their early high-risk investment—provided the company makes it to a priced round.

Because the convertible note is a form of debt, it includes a specified date by which it needs to be repaid, unless the company has previously raised money through a qualified financing (typically a larger venture capital round bringing in millions of dollars). If the maturity date of the note arrives and there has been no financing, the debt must be repaid and the company may well find itself unable to repay the note holders. In that case, the two parties have to negotiate a resolution (which is typically to extend the term of the note, increase the interest, or do something else that will be beneficial to the investors). Without a new agreement being reached, the company will find itself effectively at the mercy of the investors, who will be perfectly within their rights to call the full repayment of the note.

Convertible notes are more complicated and historically require more negotiation than SAFEs, which makes them less attractive to founders and their friends and family investors, but more desirable for professional angel investors and venture funds. To effectively negotiate a convertible note round, founders therefore need to understand the note’s mechanics. The Gust Launch Convertible Note reduces the difficulty of the negotiations (and reduces risk to founders) by distilling the most typical, industry-accepted balance between founder interests and investor interests into a standardized instrument that focuses on the most important terms for both sides, which helps keep the transactions costs down.

Here’s how a Gust Launch Convertible Note works:

• All your company’s convertible notes will share the same maturity date regardless of when they are issued
• Interest is set between 3% and 10% per year and accrues monthly
• The discount rate is set between 15% and 30% in 5% increments
• The valuation cap is negotiable according to your agreement with your investors
• The note can also contain a minimum conversion trigger
• Like the Gust Launch SAFE, it is only available to accredited investors

The Gust Launch Convertible Note provides the elevated terms and considerations that most syndicated angel groups, early stage funds, and other professional seed investors have come to expect, including interest, maturity, industry-standard discount rates, and basic investor protections and rights. Where the Gust Launch Convertible Note differs is its valuation cap: if a subsequent group of noteholders receives a lower valuation cap than an earlier group, the earlier investors will also receive the lower valuation cap, but future noteholders can receive a higher valuation cap without triggering any changes to the previous noteholders. Essentially, earlier money will always get the most optimum terms—just as risk-tolerant early-stage investors expect.

Crucially, the Gust Launch SAFE and Convertible Note work together: early-stage investors can sequentially participate in a pre-debt and debt round with confidence knowing that the company is in a good equity position to pursue a preferred stock investment, and founders can conduct multiple pre-seed rounds across multiple notes without being surprised at the cascading dilution when all their convertible instruments turn into equity at the first preferred stock raise. Unlike the one-off non-integrated instruments in general use today, the Gust Launch convertible stack is simple and easy to understand, especially in terms of how dilution will affect all parties when the company successfully raises its first priced round.

Compliance

Even though Gust Launch convertible instruments are designed to play nice with all parties in a startup’s early stages across multiple notes, fundraising is a serious and complicated matter, so founders should not overlook the immense value of good legal advice. Founders should not issue any convertible instruments—even through Gust Launch—without first consulting experienced startup counsel. Long-term company strategy and compliance considerations are idiosyncratic to each company and experienced startup attorneys are instrumental in helping companies navigate the complexities attendant to fundraising. Violating securities regulations, either at the federal or state level, can cause dramatic, long-term, and expensive problems for startups, their officers, and their investors.

Keep in mind that Gust Launch only supports issuing convertible instruments to accredited investors. Raising money from non-accredited investors introduces a great degree of legal and compliance complexity, so startups that want to accept investment from non-accredited investors will need to do so with the help of experienced legal counsel.⁶ Issuing to non-accredited investors requires additional disclosures and filings, so most startup attorneys recommend (and we only support) startups raising money from accredited investors.

For startups that do want to raise money from accredited, early-stage sources and protect themselves from dilution and negotiation challenges in later rounds, the Gust Launch convertible instrument stack is a step toward a future where all parties win.

¹ Jason D. Rowley, Q4 2017 Global Report: VC Sets Annual Records On Back Of Strong Late-Stage Results, Crunchbase (Jan. 8, 2018).

² Venture Pulse Q4 2017: Global analysis of venture funding, KPMG (Jan. 16, 2018).

³ Coyle, John F. and Green, Joseph M., The SAFE, the KISS, and the Note: A Survey of Startup Seed Financing Contracts (August 13, 2018). UNC Legal Studies Research Paper. Available at SSRN:(https://ssrn.com/abstract=3230352).

⁴ 17 C.F.R. § 230.501

⁵ For more in-depth explanations of convertible note concepts, check out The Startup Checklist by David S. Rose and Venture Deals by Brad Feld and Jason Mendelson.

⁶ Investor Bulletin: Private Placements Under Regulation D, U.S. Securities And Exchange Commission (Sept. 24, 2014).

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