Bridges or Seeds? A Primer on Your First Financing

by Nick Ares by Flickr

A lot of discussion has revolved around the appropriate structure for raising a “seed round,” which for most tech startups means a financing under $1M.  The two general options are (1) convertible debt and (2) a “lite” seed equity round.  Conventional wisdom seems to be that you should always issue convertible notes because it means fewer legal fees.  But the truth is that the economics of convertible notes are such that you’ll end up giving back any savings, and maybe a bit extra, through equity and liquidation preference.  While there are a lot of opinionated articles on this subject, my goal here is to be more balanced and simply outline the pros and cons to consider as an entrepreneur, because the right choice has a lot to do with context.

Summary

  1. How much do you intend to raise? – $1M+ likely means a full equity round. Below $500K probably means convertible notes. Somewhere in-between means the below analysis between seed equity and convertible notes.
  2. Who are your investors?  If they’ll happily sign your docs without negotiating them to death, then you should consider equity, provided you know what you’re doing with valuation. Otherwise, convertible notes are better.
  3. How long until your big funding? If you expect to raise money soon, and your Angels feel the same way, then convertible notes won’t cost you much more in terms of dilution.  But if you expect to rely on this money for a long time, and anticipate a rocky future funding environment, you should prefer seed equity.

Reality Check: The reality of many, but not all, startups today is that investors are conditioned to expect convertible notes in seed rounds, regardless of whether equity would be better.  If you find that your investors won’t even entertain the idea of a seed equity round, then you should simply use what you learn to minimize the cons of convertible notes.  Not much else you can do.

General Vocab

Debt/Notes – When you issue a “note” to someone, you are saying that they are lending you money.  Like with most loans, they are guaranteed only a fixed amount of payment, and they have the right to force you to pay it back, which can include liquidating your company.  I’m sorry, did I scare you? Good.

Equity/Stock - Generally, when you issue “stock” to someone, they aren’t “lending” you money; they’re investing it.  This means that if the company booms, they make more money (unlike a lender).  But if it collapses and loses everything, they can’t demand that you give them their money back, absent some showing of fraud

Convertible Notes - Rather than issuing stock, you issue “bridge” notes that carry a specified interest rate, maturity date, and mechanics for converting the principal and accrued interest into stock when the company raises a “qualifying” full-blown equity round.  So it starts out as debt, but converts into equity.  Very simple documents, and therefore fewer points of negotiation, which means fast and cheap.

Series A Round - The Company’s first fully negotiated financing, usually in an amount north of $1M, in which preferred stock is issued to investors, most of whom are likely professional institutional funds. Usually involves a fair amount of drafting and negotiation, with 5-figure legal bills.  Most experienced firms have their custom form documents, although they largely follow the NVCA Model Legal Documents.

Seed Equity Round - An equity financing, usually at or below $1M, that involves the issuance of simplified preferred stock.  There are probably a half a dozen or more versions of these standardized doc sets, the most popular being the Y-Combinator Series AA, the TechStars Model Seed, and the Series Seed.  You can find a great chart comparing these at this link.  The idea is that, because these docs are openly available on the internet and everyone can read them, you can agree in advance to “just use them,” and not spend time or money negotiating.

Question 1: How much money are you raising?

If you are raising around $1M+, then 99% of the time you will just do a full Series A.

  • The people you are likely taking money from will not be OK with the simplified Seed Equity docs, because of what they leave out, and the convertible notes will similarly be too simple for what investors want.
  • Also, a $1M+ raise is usually enough to justify the legal costs of drafting and negotiating a full Series A set of docs.

If you are raising less than $500K, then the vast majority of the time you will just go with Convertible Notes.

  • Exception: if you are (i) raising money from people who really don’t care much about the legal nuances of the docs, and therefore will just sign what you give them, and (ii) you, because of personal experience or experienced outside input, are comfortable with setting an early-stage valuation on your company, then you might still go with Seed Equity.  Otherwise, the amount of money being raised will not justify the legal cost in negotiating even lite Seed Equity docs.

If you are raising between $500K and $1M, then you’re in a territory where analyzing the pros and cons of convertible notes v. seed equity becomes important.  Many lawyers will just tell you to do convertible notes because it’s cheaper, but that isn’t always the case, and in some cases slightly higher legal costs may still be worth it.

Convertible Notes v. Seed Equity: Theory

Convertible Notes

Pros:

  • Shorter documents with fewer deal terms, so less to negotiate over. Cheaper.
  • Delay giving certain rights: Board seats, information rightsprotective provisions, etc. rarely are given to convertible noteholders, so at least you maintain maximum control over your Company for a longer period of time.
  • Avoids setting a hard valuation on the Company, which is good if you and your investors are inexperienced and are likely to get it way wrong.  If you set too high of a valuation, you risk (i) looking like an idiot to future investors, which may put them off from investing altogether, and (ii) having a down-round in the future, which is dilutive and makes everyone feel as if they lost money.  If you set too low a valuation, you (a) also look like an idiot, and (b) likely have limited the valuation you get in your next round because those investors won’t want to pay a significant multiple over the seed valuation, even if it’s justified.
  • Exception: Capped Notes – It’s becoming fairly common to issue “capped” convertible notes, a full description of which is beyond the scope of this post.  Basically this means that the notes will convert at the lesser of the valuation at the next round or the valuation cap that you placed in the note.  While not exactly a valuation, it will more or less be seen that way by the future investors, which removes a lot of the above-mentioned benefits of deferring valuation.
Cons:
  • Forced Liquidation: Remember that part about a lender being able to force your company to liquidate? While this rarely actually happens because of reputation and the fact that early-stage startups rarely have hard assets to grab, you’re still handing someone a loaded gun, and you will worry about it if maturity time comes around.  This is why you should choose your angels wisely.
  • Discounted Conversion, Interest: Convertible notes almost always (i) accrue interest that will also convert into equity, and (ii) convert at a discounted price to what investors in the future round are paying.  The purpose of this discount is to “compensate” the early investors for taking on extra risk relative to the later investors, which makes sense. But it also means that you are effectively giving away more shares for the same amount of money than if you would have just issued equity.  So you may save on legal fees, but you’re paying for it with more dilution.
  • Liquidation Overhang - Liquidation overhang has to do with the fact that, while the convertible notes are converting at a discount to the price in the Series A round, the liquidation preference on their shares is set at the full Series A price, so they’re getting more preference than they actually paid for. Again, you’re giving away more for less money.  This also means that the Series A investors have to share more of their liquidation preference with the convertible note holders than if the noteholders had simply bought equity, which is unfair to those Series A investors, and might result in their forcing you to change the notes in the later round. A theoretical solution is to create the discount by issuing more common stock on top of the preferred stock, but this unfortunately is quite rare.
  • Misaligned Incentives: Just to explain this quickly, when someone approaches you to make an equity investment, they want the lowest company valuation possible, because it means they get a larger chunk of your company.  When someone gets convertible notes, they already handed you their money, but the valuation keeps moving until the notes convert. So while you’re trying to make the Company more valuable, they are incentivized to want the opposite, because a higher valuation means they get a smaller portion of the Company.  This may be a purely theoretical issue depending on your investors, but incentives shouldn’t be ignored, especially when you’re relying on your Angel investors for advice and introductions to VCs.  This is also why valuation caps, explained above, have become more common-place in convertible note rounds, because they guarantee a certain percentage of your Company to the noteholder.

Seed Equity

Pros:
  • Clearly defined rights and ownership - Because you are having the investors sign definitive equity agreements, their rights and their percentage ownership are clearly set, instead of being deferred to another negotiation.
  • Aligned incentives – You avoid the misaligned incentives mentioned above.  They have as much of an interest in increasing the value of the Company as you do. No conflicts between the converting notes and investors in later rounds either.
  • Good practice for the big leagues – By having issued equity, gone through some basic equity documents, and even taken on a board member or two, you’ll be well-prepared for when you have to raise a full VC round.
  • A False Pro: It’s often claimed that a benefit of seed equity over convertible notes is that, when issuing equity, the holding period for capital gains treatment begins at issuance, but for the stock issued upon conversion of notes it doesn’t start until conversion. This is generally not true.
 Cons:
  • Valuation Risk: Issuing seed equity requires you to value the Company at a very early stage, which is risky, as described above.
  • More Negotiation and Legal Cost: As simplified and stripped-down as all the lite seed equity docs are, it’s uncommon to find investors who will sign the docs and be done with it. The rare exception would be professional early-stage investors who’ve grown extremely comfortable with a certain set of docs.  Again, choose your angels wisely.
  • Follow-on rounds slightly more complicated: At some point, you will likely need to raise a full blown venture capital round with all the bells and whistles. Normally the docs in one equity round become the basis for the docs in the next round.  Given that the firm you’re working with is likely to have their own forms that don’t completely sync with the terms of the lite seed equity docs, there may be a slightly higher cost in having to modify things to make it all work.

Question 2: Who are your investors?

If your investors are mostly interested only in the economics of your company, and you’re comfortable that they (or their lawyers) won’t start negotiating the docs to death, then the difference in negotiating/legal costs between convertible notes and seed equity probably goes away, and you should go with seed equity.  You’ll have better aligned incentives, clearly defined rights, and you won’t end up paying more in equity later on because of discounts, etc.

However, if there’s any hint that your investors are going to want to go through the docs and negotiate various points, and there usually is, then the seed equity transaction will almost certainly end up more expensive than a convertible note round.  Angel investors and their lawyers, especially in Texas, are notorious for not knowing what they’re doing in negotiations, and it will cost you.  Just have them sign simple convertible notes, and let them return to their cattle ranching or dentistry practice.

Question 3: How quickly do you expect to raise a full VC round?

Convertible notes have historically been called “bridge” financing because they were meant to be just that: some money to hold you off until you close a larger funding round that’s already in the works.  If you and the seed investors know a larger round is coming soon, then a quick convertible note round can be worth it, provided you can use this expectation to keep the discount to a minimum, and possibly keep the note uncapped.

However, if you don’t anticipate raising a larger round anytime soon, which means that you are going to rely on this money for a longer period of time, then you’re better off issuing seed equity.  You’ll avoid a long period of accrued interest, your investors won’t be worried about getting hosed because of valuation changes, and therefore you won’t have to give a substantial discount in order to compensate the investors for that risk.  You also won’t have to go for a long period of time being paranoid about that coming maturity date.

As a closing note, I’ll remind you of the reality check I mentioned.  Some investors are highly opinionated about debt v. equity and won’t let you persuade them in the opposite direction.  In that situation, you just have to go with the flow and pay attention to all the variables.

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