Course  Startup School 2019
July 22, 2019, Mountain View, CA., USA
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Carolynn Levy - Modern Startup Funding
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About speaker

Carolynn Levy
Partner at Y Combinator

Carolynn Levy was previously at Wilson Sonsini Goodrich and Rosati, where she helped hundreds of startups with legal questions. She has a BA in political science from UCLA and JD from the USF School of Law, and is a member of the State Bar of California.

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Topic: Business

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


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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 onlyfans that time frame for me. But I've seen a lot of changes to the start of ecosystem. YC's 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 home 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 use to get these bound volumes with all of the financing documents in them. They have our names on them and the date and sisters does it happen anymore? But I just thought that's what I saved some of mine. I thought this was a good picture for this. So a lot of you were going to already know what I'm about to talk about that since this is start of 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 Corporation because it's a separate legal entity and it protects the founders from personal liability. Right? We all know

that. It for a little while but eventually you're going to want a higher or grow and do 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 what most startups do is they sell a part of their company to raise money. So when you was Founders, you guys will buy common stock. That's how you become owners of your corporation. And typically you will by 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 100% 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 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 crystals

financing and round they mean exactly the same thing preferred Equity financing preferred stock round of preferred stock financing series a financing series feed 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 round note round safe financing we're going to talk about with a safe is early-stage round early-stage financing. These are all ways to describe a fundraising event where you're not selling preferred stock or, so, if you're selling

convertible Securities convertible Securities are the right to get stock in the future. It's a thing that it's not as socket 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't find fundraising documents online and you know, they come with

annotations and he signatures and it's just incredibly easy to get document back in the olden days. The only way you could find Raise This 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, it's Focus. I just remember I don't ever remember anybody ever noticing how much time it took to do these financing in the past and how much focus it took away from Founders building a company. Like I don't remember an investor or found

everything like gosh. This is taking a month-and-a-half. I so much rather be building my company. I think today people notice and have figured out that is not in anyone's best interest for people to be spending a lot of time fundraising so it's much faster. So what haven't changed preferred stock financing are no longer the way that companies raise their first do 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 I think there are two things that are super important to investors and to Founders when their fundraising and those two things are valuation and dilutions. The evaluation is just the value of your Enterprise and dilation is stock like how much you know, how much of your company have you sold? So if you are selling investors are percentage of your company, you previously owned 100% of it after you sell some you're not going to Own 100% of it that's dilation. And then 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 start up 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 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 and still super important to communicate. The old

way of raising early money was to do with series a preferred stock financing is the first letter of the alphabet. So the first time that a startup would fundraise it would be called a series a preferred stock financing 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 Capital stock. That's mostly for a series a financing just be the stuff that the founders own and that gets you price per share you take that price per share and you would sell your preferred stock to your investors.

So now go back then angel investor Jim. So you guys have heard about Angel Investors. They used to aggregate into Consortium. And so they would tend to all band together and write one big check. So Fourier 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. Angel groups now checks doesn't really happen like in two sources anymore. Anyway, 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 the preferred stock which means voting rights liquidation rides Pro rata rights, and then you'd end up with a set of documents that go in there. And there was another spell five of them this took months and it was to cost anywhere in legal fees from 25 to $100,000. Okay, so what's broken about that? Well, that's pretty elaborate right takes a long time. It cost. I just told you we could cost you know, 25 to a

hundred K 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 going to touch on this the cost of starting a company has decreased a ton over the years not so much for software and e-commerce companies of sorry not so much for hard tech companies, but software is e-commerce companies that the price of actually starting these startups has way decreased and as a result companies actually don't need to raise 1.5 to 2 million

dollars just to get off the ground and having to do these long elaborate expensive financing. What's 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 it series B financing. Sometimes it would run out of money in between and so often times the company would then go to its lead Finance this lead investor rather in the in their series a financing and they would ask for a bridge loan a bridge loan is a jet bridge between two financing and these

involve the note purchase agreement and a convertible promissory note and sometimes they would be common stock warrants that will go with it but basically was a stopgap measure in between financing and keep in mind he's fine. And since I just told you were long and expensive so you aren't just doing them all the time and this is where Bridge Loan Finance has came in. At the heart of the of the bridge loan 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 but it also had a mechanic

that would cause it to automatically to 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 be your convertible promissory notes, but convert into shares of series Beeman that financing happened but along the way and I honestly don't remember how this all came about the people start to realize that just the convertible promissory note. Nestor the no purchase agreement or the, so I can warn that the convertible promissory note itself could actually be used as a standalone documents 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 the 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 to people still hired lawyers for these convertible notes, but only negotiating one document and you're only negotiating maybe maturity date and interest rate what's 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 the effort you can 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. It's still alone. So it's debt. We did a why so you 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 as an acronym that stands for simple agreement for future

equity. I like 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 price 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 because we didn't think it made any sense to use debt to sell Equity. Angel Investors are

not lenders and start of the Blue Monkey Bar hours write the whole point of taking someone's 50k and turning it into a billion dollars with everybody that those investors want to be stockholders and startups don't want to be thinking about accruing interest or you know, when is there no going to be do so, we thought that it made a lot more sense to take all the debt piece all the Heart 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'm actually already done that. So there are

other start of school video lectures that you guys can watch to hear a ton more about the safe the this is a this is the YC page. This is their resources to say Finance 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's tons of mass examples to use to show you how it converts. So please visit that didn't happen. They are still the primary way that startups raise money. They're no longer the way that most artists raise their do their first fundraising but bills into the safe and other

converter. Securities like promissory note is the whole concept that eventually the company's going to do a price around and those convertible Securities are going to convert into that price round somos top 10 companies will do their first fundraising on a safe convertible promissory note and then they will do a price around afterward and all those safes in convertible promissory notes will convert into stock cannot convert unless there is a price on done eventually. So so price rounds are still modern. They're just not the modern way to raise her money to first time and also I should

mention kind of laughing at them because they involve a lot of documents and we used to put them in these letters abound clothing volumes for the lawyers put on the bookshelves improvements as well. They are much more standard Than I Used to Be and they are also all five of those price round documents. You can get them online these days. He's still everyone tends to still hire a lawyer for them. But okay, so did we perfect Modern early-stage financing by use it by by introducing the safe and buy, you know, everybody using convertible Securities to raise money the first

time and I would say we've come a long way but I don't think it's quite perfected and the reason is because I mentioned solution a few minutes ago, so convertible Securities because people who hold investors that whole 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 still sell convertible Securities, they're not on the table. If you're still 100% owner if all you've ever done is sell convertible securities. The Day of Reckoning is coming when you do your price around 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 sell 30% of your company top to all of your angel investors. So don't let that happen to you. The other things that has that is to be aware of with early-stage fundraising using convertible Securities is because it's so flexible and easy to raise custom amount of money, you know, you can raise a hundred K and decide that

you can bootstrap on that for a while and then maybe in a couple months to raise 50k cuz you just need a little bit more that's very flexible. But you can end up with a ton of investors and we call that a party around right used to be that in the old days. He's maybe have 6 to 10 investors and now you can have you know, 2535 different Angel Investors if That's great. You got the money. It's not a bad thing, but it can be administratively really challenging because they become stockholders when you do a price round and then you need their consent cuz you know corporations have stockholder

consent 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 convertible rounds is that investors write smaller checks they tend to and they don't care as much about them. 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 just written a check and gotten a convertible security as opposed to riding a really big check and being a stockholder. It can mean the difference between how much attention they Video again can be good can be bad but it's just a side effect my summer 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 is I said before is focus. If you don't have to spend a lot of time to go shave and documents that you can get the money in the bank really fast. You can go back to building your company, which is what you want to put your investors. What is specifically for this crowd. This is not San Francisco. This is Boston. What's a sand 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 than earlier was doing financing this way. So maybe a

little bit of Education involve you may have investor to 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. Play outside of the Silicon Valley, but for the most part I would recommend that you. Approached by a 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 how many? If she starts with down the road into futuristic. So I did not think repeat the quote. Okay. So if you take small checks from Angel Investors to do your early fundraising do visas. Look at that in a negative light when you go to them to do your price round, I would say no that is they don't I mean you've you've you've taken small amounts of money you've gotten this far right like you had all these Milestones are now going to be season St. Lucia my priced round.

I think the fact that you raise money from angels and Texas 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. Do you ever recommend something like think we crowdfunding? So using regulation crowdfunding great question, you know, I thought that was super interested since I've been practicing for 21 years. Like that's a huge change, right and the SEC change the rules you can now you can now actually generally solicit and have your company B crowdfunded where actual strangers can buy your

equity. It has a lot of rules and regulations around it feel like it's still in the testing phase like no y c 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 work. Okay. Yeah, the company doesn't raise

the following round of Jose sold a bunch of safes to investors the safe only converts in the event that you raise the price around your company gets sold or you go public and there is absolutely this concept that will 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 without their it is exceedingly rare for a company to be able to take a tiny amount of money that it raises from his plate holders and then go on

and never need to I'm not saying couldn't happen but it's pretty lyrics. It's going to be in the founders want liquidity to write. So how are the founders ever going to get liquidity if they don't sell or go public or you know, raise more money. So yes, of course, you will surely meet some investors who raised that exact point with promissory notes, at least. It was that it could be repaid. They knew they were going to get their money back. That's not true. It's a safe. But again, it is like it's a gamble 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 going to raise money again or that I'm ever going to do anything this company than maybe it's not the right in You know, I can respond to that but basically in all my years of practice, I only ever had one client that hit only raised one round. Like it just companies need more money to grow, the way I look at it. Okay, what's the threshold for how do you know which convertible security or should you do a price on how do you know basically what you're what to

do. I'm glad you asked that question because I did I wanted to make his point forgot PC wants to give you 5 million dollars that you're very first fundraise do it. 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 wise dilution Wise money-raising Wise do it. Otherwise It does not matter how much are 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 y c 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 like it made me nervous thinking about it, but 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 going to 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 it safe just because someone wants to do a 500000 track the dilution. I'm glad you asked that again. This is all in that other lecture. But but because you asked if he wanted to know what the key terms of the SAR valuation, that's it. That's the only thing you have to negotiate in. And so and that's probably 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 mass about how it converts and that plays into solution to suit you do have to figure that out. And we do have a version of the safe. If you go to the resources have you can see all these we do have a person to say that doesn't actually even have evaluation in there. So in theory if you can get away with not even negotiating evaluation with your investors, and you could try it that way. So that is so that's an option. That's really that's the only thing you need to negotiate and like I said, no lawyers cuz what do you need them for? Beretta

special case to the state what will happen if we are not going to have right here on this person investors saying let's add something to the safe that address the issue of what if you never do a price around in my safe never conversed 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 what the convertible promissory notes he has to do is they would have an a term sheet attached them as an exhibit and at the maturity date the company hadn't already gotten the price to 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 that's a route. I could have taken with the face, but honestly that's just more stuff to negotiate and I didn't want that to be part of the state. So that's not but if you are invested, let's just put that just have this automatic conversion of here the term you can totally do that. Two more questions. Okay. We're not charging us a front for the pattern later. 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 same as a weird instrument to do these fat because the safest fundamentally like give me the money up front. I'll give you the stock later. If you're not getting any money, if you're saying they say I'm getting my services and I'm just going to give you stuff. I mean, I probably it's probably not the way I would handle it. Yeah, probably I mean it. Yeah, I don't really think of the safe as being the thing you can use. Tell me like what you're talking about is

how do I get to really cheap founder likes talk to someone who's done us the favor for me and I wouldn't use the safe for that. I think there's other ways you can do that and we're doing an AMA on Friday. Like these kinds of questions we're going to do an am am asking to have my other YC legal team with me and we can answer questions like that and give you a few more ideas the probably not the safe for that just to answer your question. All right.

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