Welcome to the 48th episode of Deep Tech Catalyst, the channel by The Scenarionist where science meets venture!
Founders must learn to weigh the trade-offs between dilutive funding, which involves giving up equity, and non-dilutive funding, which allows them to secure capital without sacrificing ownership.
Each route has its implications for control and long-term business strategy.
🧠 In this context, some good questions can be:
What exactly is the distinction between dilutive and non-dilutive funding?
What options and strategies do founders have in the early stages to exploit these opportunities efficiently?
What are bridge funding rounds, and what might be the best funding strategies to approach them?
Let’s explore this exciting topic with Dave Anderson, Founding General Partner at Beat Ventures!
Key Themes Covered:
🍰 Key Differences Between Dilutive and Non-Dilutive Funding
📝 SAFE Notes vs. Convertible Notes
🚀 SAFE Notes and Dilution: A Simulated Scenario for Early-Stage Startups
🌉 Bridge Funding Rounds for Deep-Tech Startups
💰 When to Consider Venture Debt
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Before diving into it, please note: This content is provided solely for educational and informational purposes and should not be construed as financial or legal advice. Entrepreneurs and investors are strongly encouraged to consult with qualified legal or financial professionals to navigate these areas effectively.
🍰 Key Differences Between Dilutive and Non-Dilutive Funding
The primary difference lies in ownership. In dilutive funding, investors provide capital in exchange for a share of the company, meaning founders give up a portion of ownership and control. Ideally, founders could secure all the capital they need without giving up any equity, but that's rare. Generally, attracting investors means trading a part of the business to gain the resources necessary for growth.
Types of Dilutive Funding
Venture capital (VC) investors focus on dilutive funding, where they invest for a percentage of ownership in the company. This approach includes various funding sources:
Micro VCs – Smaller funds focusing on early-stage investments.
Family Offices – Wealthy families who invest directly in startups.
Corporate Venture Capital – Large corporations offer funding through their venture arms.
Institutional VCs – Traditional venture capital firms with larger capital pools.
Angel Investors – Individual investors who provide early capital.
Growth-Stage Investors – VCs who invest in later stages as the business scales.
Each of these investor types provides capital in exchange for a share in the company, impacting the founder’s ownership stake as they accept more funding rounds.
💡 Spotlight: What is a Micro VC?
In the venture capital landscape, a micro VC stands out due to its smaller scale and distinct investor base. For those unfamiliar with venture capital structures, a micro VC typically manages under $50 million in assets, also known as Assets Under Management (AUM). Unlike larger venture capital (VC) funds, micro VCs don’t usually have institutional investors, also known as Limited Partners (LPs), backing them.
Key Differences Between Micro VC and Traditional VC
Micro VCs primarily draw their investment capital from sources like family offices and high-net-worth individuals, investing on behalf of these private backers. This sets them apart from traditional VCs, where funds above $50 million often have institutional LPs, such as pension funds, university endowments, or large-scale financial organizations.
Non-Dilutive Funding Options
Non-dilutive funding, on the other hand, provides capital without requiring founders to give up any ownership of their business. In the U.S., several non-dilutive options exist, particularly beneficial for Deep Tech startups:
Government Grants – The Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs provide grants specifically for tech startups.
Nonprofit Grants – Some nonprofits fund startups, particularly those with social or environmental missions.
Loans – While rare, some startups might be eligible for loans, though these come with repayment requirements rather than ownership relinquishment.
Venture Debt
A lesser-used option that involves taking on debt, which may be less dilutive than traditional equity funding but still has some financial impact. We will discuss this later.
📝 SAFE Notes vs. Convertible Notes
When Deep Tech startups are ready for their first round of dilutive funding, several options are available, especially for those with early technology levels close to the prototyping phase, e.g. TRL4 or TRL5.
The most common 2 primary instruments at this stage are SAFE notes and Convertible notes.
Convertible Notes: Debt with a Conversion to Equity
A convertible note is a form of debt that accrues interest and has a maturity date. If the note doesn’t convert into equity, the funds must eventually be repaid.
Key aspects of convertible notes include:
Interest Accrual – Interest builds over time until the note converts into equity.
Maturity Date – If not converted by a specific date, the startup owes the capital back to the investor.
SAFE Notes: Simple Agreements for Future Equity
A SAFE note, or Simple Agreement for Future Equity, is often used for early-stage, Deep Tech startups. It was developed by Y Combinator to simplify the investment process. Essentially, it’s a streamlined form of a Convertible Note that allows founders to raise funds more straightforwardly.
SAFE notes are widely used because they are:
Cost-Effective – Lower legal fees make them a practical option for early rounds.
Simple to Execute – The agreement is streamlined to reduce complexity for both investors and founders.
Investor Perspectives on SAFE Notes vs. Convertible Notes
From an investor's standpoint, choosing between a SAFE note and a convertible note often comes down to cost-effectiveness and alignment with the founders' interests.
SAFE notes have become a popular choice in early-stage investments, particularly at the seed stage, where legal simplicity and shared interests are crucial.
🚀 SAFE Notes and Dilution: A Simulated Scenario for Early-Stage Startups
In early-stage startups, founders typically begin by distributing ownership between themselves as common shares. Let’s explore a simulated scenario.
If a company is founded by a CEO and CTO as equal partners, each would own 50% of the company. These common shares are essential to understand, as they’re usually paid out last in case of liquidation or other financial events.
Bringing in Investors: Preferred Shares and Dilution
When outside investors come on board, they receive preferred shares, which offer certain advantages over common shares. Raising funds right from the start in a priced round—especially when the company’s valuation is low—can be highly dilutive, meaning the founders would give up a large portion of ownership for a relatively small investment.
SEE ALSO:
Using SAFE Notes to Delay Valuation
A SAFE note is a popular way to defer formally pricing the company until it’s ready for a priced round. For example, if a startup raises $1 million through a SAFE note with a post-money valuation cap, this arrangement helps manage ownership and minimizes dilution until a later stage. Once the SAFE note converts in a future priced round, it factors in all previously raised SAFE notes and shares.
Key SAFE Note Terms: Valuation Cap and Discount Rate
SAFE notes typically come with 2 main terms:
Valuation Cap – This serves as a ceiling on the company’s valuation at which the SAFE converts. While it’s not a formal valuation, it’s used as a practical benchmark for the next funding round.
Discount Rate – In some cases, the note includes a discount rate, offering the investor a discount on future share prices.
Most SAFE notes follow the post-money valuation cap model, providing a clear sense of the eventual conversion terms and a general benchmark for the next priced round. When taking on funding through a SAFE note, it’s crucial to set clear milestones with the investor to guide progress toward the next funding goal.
For instance, a startup may target a priced round within 12 months of the SAFE note issuance, with milestones defined along the way to track growth and progress.
if you were to raise a price round from the very beginning, when your company is not worth a whole lot, then any money that you bring in would be highly dilutive. So what a SAFE note allows you to do is basically postpone pricing the company until you raise that price round.
🌉 Bridge Funding Rounds for Deep-Tech Startups
For early-stage startups, getting funding has become tougher lately, thanks to rising interest rates and inflation. This environment impacts the entire investment value chain, from Limited Partners (LPs) to Venture Capitalists (VCs) and, ultimately, to founders.
High interest rates mean that LPs often find better returns in treasury bonds or other assets, reducing their interest in venture capital, which in turn limits available funding for startups.
In this challenging landscape, a bridge round can be a vital survival tool, providing capital to help founders meet key milestones until the next major funding round.
Key Considerations for Bridge Funding
Before embarking on a bridge round, CEOs need to have a clear strategy and purpose for the funds. Here are a few critical factors:
Define the Bridge Goal – Founders should identify specific milestones or goals they intend to achieve with bridge funding. This clarity reassures investors and aligns everyone toward a common objective.
Survival First – When survival is at stake, pulling in capital from multiple sources may be necessary. Founders should be prepared to connect with more VCs than usual and possibly raise smaller amounts to keep the startup going.
Play the Numbers Game – Given today’s funding landscape, founders will likely need to speak with more investors than usual to secure smaller sums of capital.
Bridge Round Options: SAFE Notes and Non-Dilutive Funding
A common strategy for bridge funding is using SAFE notes, which allow startups to delay formal valuation, providing flexibility. For many companies that raised capital in the high-valuation environment of 2020-2021, a SAFE note bridge can help them avoid a down round while they work toward the next major funding milestone. It’s a way to secure necessary funds without pricing the round, offering breathing room without the perception of losing value.
Adapting Business Plans and Objectives
In addition to securing bridge funding, startups in this environment must often reassess and adjust their business plans. Reducing objectives and milestones into smaller, more achievable steps can make the business plan more adaptable to limited funding.
Founders today must also keep in mind that VC expectations have shifted.
For instance, a general rule in the past was to reach $1 million in Annual Recurring Revenue (ARR) to secure Series A funding, but now, $2 million ARR is increasingly the benchmark.
If possible, startups should aim for “default alive” status, meaning they can survive without new funding if necessary, allowing them to weather prolonged fundraising periods. In cases where capital is especially scarce, non-dilutive options like grants can offer critical support to help founders through tough financial periods.
💰 When to Consider Venture Debt
Venture debt and venture capital are complementary, but venture debt providers typically require that a startup has secured prior VC funding.
The reasoning is simple: venture debt providers want assurance that the company has already received backing from credible VCs and demonstrated progress with its product.
Despite each venture debt provider having a detailed checklist, here are three important criteria that they look for:
VC Backing – Most venture debt providers require that startups have credible VC investors already on board.
Product Maturity – The product should be sufficiently de-risked, meaning it has demonstrated potential for success and growth.
Financial Milestones – Some financial milestones and operational targets need to be in place before venture debt is approved: it is often secured around the same time as the closing of a venture capital financing round.
SEE ALSO:
Combining Venture Debt and VC Funding
Typically, startups turn to venture debt once they have market traction and some revenue, but before they reach full commercial success. While combining venture debt and traditional bank loans is possible, it’s uncommon before a startup shows clear revenue streams and market fit.
Instead, venture debt is often utilized alongside VC funding, serving as an extra layer of financial support during growth stages.
Ultimately, venture debt is a strategic tool startups can leverage to ensure continuity, particularly when expanding or scaling their operations, without immediately seeking another equity round.
What venture debt allows you to do is extend the runway just in case you run out of some of that venture capital money. In exchange for providing this extended runway, the venture debt providers will issue warrants that are subject to certain milestones that you agree to with the venture debt provider. And the warrant is simply an option that they can exercise at any point, where they have a strike price that is lower than whatever the future round’s price is. And they're effectively able to acquire equity at a lower price.
