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Startup School Winter 2020
January 20, 2020, Online, USA
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Carolynn Levy - Modern Startup Funding
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About the talk

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.

You can find the lecture slides and transcript here: https://www.startupschool.org/videos/79

Find more Startup School and YC content at https://www.startupschool.org/library.

00:00 Intro

01:02 The basics

04:03 What has changed?

04:37 What hasn't changed?

08:15 Time & cost

09:43 The transition bridge loan financings

10:37 Convertible promissory notes

11:27 Modernization of the convertible

12:47 Details about the safe

13:27 When do price rounds happen?

17:27 Takeaways

21:10 Q&A

About speaker

Carolynn Levy
Partner at Y Combinator

Carolynn Levy is a partner at Y Combinator. She 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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I like Kevin said, I'm going to talk about modern startups financing. I have only been practicing law for 21 years. So what sold and what's new onlyfans that time frame for me. But I've seen a lot of changes to the startup ecosystem. Why she'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 took this picture. These are called closing volume 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 to have our names on them and the date and then happen anymore. But I just thought this would I save 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 a corporation because it's a separate legal entity and it protects the founders from personal liability. Might we all know that you can

probably found her for a little while, but eventually you're going to want to hire 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 out with Founders, you guys will buy common stock. That's how you become owners of your corporation. And typically you will by 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 as completely different class of stock, called preferred preferred stock is more expensive. Another kind of basic thing. I never know. What does, you know, what, what kind of terminology people know, so I thought I'd be really helpful to take a look at the

terms right here. So Frisco financing in round, they mean exactly the same thing. Preferred Equity financing preferred stock round of preferred. Stocks financing series, a financing series C financing these things. All basically mean the same thing its fundraising by selling preferred stock at a calculated specific price per share things. Term convertible round 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 while 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 me to stop later. I see 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's signatures, and it's just incredibly easy to get documents back in the olden days till sunrise with, 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 focused. 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 Josh. This is taking a month-and-a-half so much rather be building my company. I think today people noticed 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 I haven't changed preferred stock financing are no longer the way that companies raised 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 dilution. The valuation 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's, you previously owned 100% of it. After you sell some, you're not going to

own a hundred percent 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 enter 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, 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 the founders own and that gets you a price per share. You take

that price per share and you would sell your preferred stock to your investors. So now I'm sure you guys have heard about Angel Investors since orson's and so they would tend to all band together and fight 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. Angel groups now, checks in two sources anymore, delete 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 for talk which means voting rights liquidation rides pro-rata rights, and then you'd end up with a set of documents that go in and it was to cost anywhere in legal fees from 25 to $100,000. Okay. So what's broken about that? That's pretty elaborate, right? Takes a long time. It cost. I just told you it could cost, you know, 25 to 100 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.

The cost of starting a company, has decreased a ton over the years, not so much for software and e-commerce companies that are not so much for hard tech companies. But software is eCommerce. Company has its price of actually starting a startup's has way decreased and as a result companies actually don't need to 1.5 to 2 million dollars, just to get off the ground and having to do these long elaborative Spence's financing. Was not worth it. So it just wasn't at all

flexible when it 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 two often times. The company would then go to its 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 bridge between to financing and agreement and a convertible promissory note. And sometimes there was a common stock warrants that will go with it. But basically was a stopgap measure in

between financing so I can keep in mind, he's financing. So I just told you were long and expensive. So you aren't just doing them all the time and this is where Bridge Loan finances came in. At the heart of the first one was his convertible. Promissory note and a convertible promissory note was a loan. It had an interest rate that had a maturity date. It was a bit, 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, be your convertible

promissory notes for convert into shares of series demon, that financing happened, but a long way and I honestly don't remember how this all came about. The people start to realize that just the convertible promised, our nose not messed with a no purchase agreement or The Comstock warned. That the convertible promissory note itself could actually be used as a standalone documents and you could use it to fund companies and you pick me up at the fun, not as a bridge, but actually just the very first time that a company needed money. Sophisticated 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. People still hired lawyers for these convertible notes, but only negotiating one document. And you're only negotiating the interest rate is 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 just if you can just transfer

50k from an angel. But it's still a promissory note and a promissory note. It's still alone. So its debt. We 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 that stands. First simple agreement for future equity. I like that, so no, it is one simple document. It is a convertible Securities that I showed you all those terms. It's a convertible Securities that converts into the dock. When the

company raises the 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 yet, which is why it needed to know what was broken about convertible, promissory notes. They were only one, document saver cheap, they were fast because we need any sense to use debt to sell Equity. Investors are not lenders and borrowers, write the whole point of taking someone's 50k and turning it into a billion dollars. Is everybody 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 due. So we thought that it made a lot more sense to take all the debt. Peace. All the, Start out of convertible promissory notes, but retain all of the convenience of them. So I had to do an entire lecture on how to use the state and what it's all about that. I'm packed already done that. So there are other stars, video lectures that you guys can watch to hear a ton more about the save. The, this is the way I see Paige. This is their resources to

say, Finance documents at the top. We have a user guide that is kind of slow, but it has a ton of really good information in its tongue. The masked examples to use to show you how it converts. So please visit that they are still the primary way that startup prize money. They're no longer the way that most startups raise their to their first fundraising but built 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. So most often companies will do their first fundraising on a state Virgo, promissory note. And then they will do a price around afterward and all of those safes and Commercial promissory notes will convert into stock cannot convert unless there's a price on 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 was kind of laughing at them because they involve a lot of documents and we used to put them in these letters. L a

n, a used to be and they are also all five of this price round document. You can get them online these days. He still intends to still hire a lawyer for them. But perfect. Modern early-stage financing by use it by by introducing a 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 by Lucian a few minutes ago, so convertible

Securities because people who hold investors, that whole convertible Securities and stockholders, you actually don't, it's very hard to tell how much ownership of your company you have sold when you still selling convertible Securities, they're not. All right, you're still a hundred percent 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. But you got to do the work. There's no

excuse for being surprised by realizing you sold 30% of your company to all to all of your angel investors. So, don't let that happen to you. 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. I 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 one of investors

and we call that a party around right used to be that in the old days it maybe have six to 10 investors and now you can have you know, 25-35 different. The money, it's not, but it can be administratively really challenging? Because they become stockholders when you do a price round and then you need their consent, corporations have stockholders, and sent kind of hard to Chace 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 round is that investors are a small check. 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 and make introductions for you. They'll help you with strategic advice. So, having a sister who just written the check and got in a convertible security as opposed to riding a really big check. If it can mean the difference between how much attention Are you

again? Can be good, can be bad, but it's just a side effect. My summer slide. Okay, so are now using to Vertical Securities, like the safe. Selling preferred stock and price rounds is still modern. It still happens. It has to happen. It just tends to happen later it since to be your second fundraising. Not your first. The whole point is. I said before its focus, if you don't have to spend a lot of time to go Shady 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 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 I may be 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 a convertible. Promissory note or you may have investors, are just like what you talkin. 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. Approach fundraising breakfast, ideas Newington verbal Securities just because it can be done so fast and so flexibly. Do you want me to do question? How many? if she starts with down the road into the future and fundraising, so I did not think it. Okay. If I'm raising these look at that in a negative Light of Christ, round

small amounts of money. You've gotten you had all these Milestones are now going to be Seasons thing to do my price round. I think the fact that you raised money from angels and Texas mulch, X 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 we crowdfunding? So, using regulation crowdfunding great question, you know, I thought that was super interesting since I've been practicing for 21 years, but that's a huge change. Write

the SAT change the rules, you can now 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 to my knowledge has done that yet. So I don't have any personal experience with it like dyed but I know some companies have done it and it 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 initiative to speak on it with a pros and cons work. Okay,

what happens? If the company doesn't rain the following from wondering what happens, if you never sold a bunch of safe to investors this, they've only converts in the event that you raised the price around your company gets sold, or you go public and there is absolutely this concept that will what if my company just putter? The long 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 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 needs couldn't happen, but it's pretty rare 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 raise more money? So yes, of course, you will surely need some investors who raised that exact point promissory notes, at least. It was dead. It could be

repaid. They know they're going to get their money back. That's not sure what the face. But again, it is like it's a Gamble and Esther. 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. You know, basically in all my years of practice, I only ever had one client, that it 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? What 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 because I forgot wants to give you 5 million dollars as your 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 lies, 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. 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 wanted to do convertible promissory note and

that's how you're going to get to the next Milestone and you need that money ticket price. It's better than dying. You know, should you not do? Because someone wants to do a 500,000 track the dilution 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 say our valuation. That's it. That's the only thing you have to negotiate in the state. So I have to decide what valuation you're going to plop into the face 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 would you have a version of the safe? If you go to the resources, have you can see all these two-faced? It doesn't actually have a valuation in there. So in theory, if you can get away with, not even negotiating evaluation. So that 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? We have any better at these trinkets.

Jesse do any special case in the face. After thing. Let's add something to the safe that that will address the issue of what if you never do a price around in my save, never conversed. Sure. 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 that the company had already gotten the price 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 the 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 face. So that's not. But if you are interested, let's just let's just have this automatic conversion of here. The term you can totally do that. Timber equipment, okay? For the pack leader? Okay. So his question was, what if you wanted to give your saying, what if I want to give someone

equity for services rendered because I don't want to give them cash. Okay, so the state has a weird instrument to do. Do you spell? 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, 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 same, you can use. Show me like what you're talking about is how do I get

really cheap? Founder likes. Talk to someone who has done us the favor for me and I wouldn't use the stay 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 a.m. A.m. Asking to have my other wife, his 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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