As a startup entrepreneur, you might have come across the term CLA and were wondering what CLA stands for in business. You might have even been offered a CLA and weren't sure about the pros and cons of such an offering. In this blog, we'll try to unpack this subject. There is a lot of legal and finance stuff going on, so we'll take it step by step, but if we missed anything – feel free to contact us.
Disclaimer 1: We are entrepreneurs and investors, NOT lawyers.Unless you are doing a SAFE agreement (more on it later), always consult a specialized startup lawyer before making any move.
Disclaimer 2: None of the links are affiliated, and we don't have a commercial relationship with any of the linked brands.
With that out of the way, let's begin.
What is equity in a startup?
Equity in a startup company, or any company that matters, is ownership in that company. Startup equity can be split between its founders, investors, advisors, employees, and service providers. Since a technology startup's valuation starts low and grows aggressively over time compared with traditional companies, it is common for stakeholders to look for equity ownership due to the hidden potential.
Let say Eggsy(equity… Eggsy… close enough) invests $100K in his friend's startup Moonshot inreturn for 10% ownership of the company. In this scenario, Eggsy holds equity in the company. If the company is acquired the week later for 30 million dollars,Eggsy would be entitled to get 10% of that, which is three million dollars. Nota bad nor realistic return. In a more realistic scenario, the company would hire a software engineer, develop a prototype, and get to a point where they have $20K in the bank to raise more funds. If they fail to do so, they would need to close the company to pay all contractors and employees. While there might be some money in the bank, Eggsy, asan equity owner, would only be paid after all other contractors and debt owners.So the 20 thousand dollars might be split between the office owner, the cloud provider, and the software engineer. While Eggsy invested $100K, he might be left with nothing, simply as he's the last in line to receive money if the company is closing.
The investors of Equity financing are entitled to a portion of the company. This means that any equity financing will require setting a valuation to the company.
Equity is also referred to as internal financing, and you should think about it as bringing in a partner.
What are the rights of equity owners?
In traditional companies, equity holders are entitled to a piece of the company's profit, distributed in dividends. In a startup company, the equity holders will most likely sell a portion of their holding when the company appreciates and gain some liquidity,for example, in an M&A deal or an IPO.
In addition and dependent on the founder and investors agreement, the equity owners get some level of control of the company business by appointing members to the board of directors.
What is startup debt?
In its simplest form, debt is a loan.
The debtowner provides the company with cash in return to promise that the money will be returned by a specific time with some interest payment. Since loans require some security and early-stage startups have very little securities to give to the debt owners, simple debt is scarce in such scenarios.
Debt is also referred to as external financing.
Since the debtowners don't get a percentage in the company, no valuation needs to be set in such a financing event.
What are the rights of debtowners?
Unlike equity owners, debt owner's potential return is capped by their loan plus the agreed interest. However, if things go south, they have priority over equity owners in getting their money back.
Owners of debt do not control the company's business, but they have a trump card in asense. If they feel the company is at risk of not returning their debt in full, they can apply to the court to force the company to be bankrupt, and all its business stopped to ensure they get their money back.
Let go back to Moonshot. After raising $100K from Eggsy as an equity round, Moonshot founder decided to raise another $100K, this time from Debbie ("Debt Debbie for you"), the debt owner, with an interest of 10% per year.
Let's look at the two scenarios we had before. At a $30M acquisition, Eggsy would get $3M, and Debbie will get, well,$100K plus her interest. If the company goes belly up, Eggsy will get nothing,and Debbie will be entitled to all the money in the company, up to her debt plus interest, so potentially 100K plus interest, but more realistically, justa portion of that. However, if Debbie feels the company is getting to that position,she might force the company into bankruptcy while most of her debt can be returned.
Debt vs. equity in a startup
What we described till now is mainly from the investor perspective, but of course, the flip side of things is from the founder's perspective.
Taking in new equity investors (internal financing) meaning bringing in new partners. The share that they get today might be worth a hundredfold in the future, so equity financing is perceived as expensive. Moreover, investors who get equity are great when you get along, but it is tough to split if both sides agree if the relationship doesn't work out. This might create tension within the company and cause paralysis.
What is a Debt/equity swap?
If debtowners identified the company situation might not enable it to return their debt,they might force it into bankruptcy. However, they might choose to offer to swap their debt for equity in the company in some cases. The swap ratio will be negotiated between the existing shareholders and the debt owner. This is most often done when the probability of getting the debt is low, while the debtowners believe they can help turn around the company, in which the equity will be worth more. At the end of the process, the debt owner would forfeit their debt and own company equity.
This brings it to the reason why we all got to this blog, to begin with.
Convertible debt, convertible note, and convertible loan agreement, or CLA
Equity rounds require setting a valuation to the company and are more complex from a legal perspective. However, startup companies have very little in the form of securities they can offer to debt owners.
For that matter, convertible debt was created.
Convertible debt is a form of external funding granted to the company under an agreement that it would be swapped or converted into equity at specific terms.
A convertible debt, convertible note, convertible loan, Convertible Laon Agreement (CLA) are all interchangeable names.
Convertible debt term sheet
Convertible security will have the following main terms:
- The issuer of the note (the company)
- The investors
- How much money is being invested
- The terms of conversion
- How long before a conversion takes place (e.g.,the maximum period of two years).
- What class of share will the debt be converted to.
- Any discount granted to the debt owner in the conversion.
- Automatic conversion
Events that trigger automatic conversion are typical conversion cases, usually in the next round of equity financing.
- Voluntary conversion
This term dictates the right for the debtholder to convert into equity, even if the terms of conversion and automatic conversion events did not occur.
- Liquidation events
What happens to the debt owner if the company gets liquidated, such as in an M&A event.
Because a CLA term sheet is still somewhat complex, Y-combinator came up with a template for SAFE.
YC SAFE document
In 2013, YC introduced the SAFE (Simple Agreement for Future Equity), a template for convertible securities agreements.
Since then, the document went through some iterations, and today it is the most widespread form of convertible agreement for startups.
We highly recommend you use YC templates, but please stick to the template without changing a word if you choose to use them.
Some lawyers like to temper with it, offering their suggestions. More often than not, they would make the document invalid and add risk to the process.
If you choose to use the SAFE document as is, you can usually do it without any lawyers to reduce the fit (with the added risk, but it is negligible in this case).
Also,make sure you go through the different document types (with/without discount,capped/uncapped, and yc pre-money safe vs. yc post-money safe) and plot different scenarios to make sure you choose the right solution.
Pre-money SAFE is not very common today, and we would advise you stick with post-money SAFE.
On top of being standard agreement, a SAFE is not debt. It doesn't carry any interest to the investor.
A SAFE doesn't "expire" on a set date, but on one of three events:
- When the company raises a round (that is considered a qualified round)
- When the company is being acquired in an M&A transaction
- When the company is being closed or dissolved.
For a startup, is debt cheaper than equity?
Generally speaking, because debt is limited in valuation, it is cheaper for the company.
However,the following considerations should be taken into account when deciding what's suitable for you:
- Debt may make your company fragile.
Because the debt owner can decide there is risk in getting their money back,they may force bankruptcy even if they hold a small debt.
- Many CLA/SAFE investors will require you to put a cap on their conversation valuation. Future investors may be indifferent to the cap. But, we've witnessed cases where the cap on the SAFE becomes the valuation of the coming round.
- Collecting money through many small SAFE agreements may create a skewed view of the company's ownership.
The cap table will not reflect any of the debt owners, but on conversion day ,the founders might be surprised with how much diluted they get.
Venture debt is external financing that does not convert. It is more like a traditional loan or commercial debt.
In the startup ecosystem, few players specialize in providing venture debt.This is usually granted to companies who already raised their B round with notable VCs. Before that stage, the risks level is too high.
The access to the venture debt firm would also be in the form of introduction from the VCs at the table, but we can mention SVB, and Kreos.
Non Dilutive financing
Subscription companies, especially SaaS companies, can access debt financing if they provide their accounts receivable as securities. Examples of companies that support this model are Pipe and River. We would mention that a SaaS company can offer a favorable discount to annual cash paid subscription, thus getting its financing directly from its customers. Of course, these need to be modeled and understood because they affect the brand, pricing, complexity, andmore.
What is the preferred model for startup financing?
As always in the startup world, the preferred model is the model you have access to.
If you are a first-time CEO, the chances are it would be hard for you to find such an opportunity, but if you are offered an uncapped nodiscount SAFE, it's probably the best option.
Realistically, you'll need to finance your company to get to the next stage, and it depends on the types of financing available to you in the market.
The critical thing to remember is that while financing is crucial to your company, early-stage companies should be focused on: identifying their customers, understanding them, building solutions they care for, and servingt hem diligently.