You generally have four different options for how to structure your seed financing: , debt, and . For business, tax and other legal considerations, however, using convertible debt or preferred stock are typically the two best options for an early-stage company.
Selling common stock to investors is typically problematic because it either results in too much or creates tax problems when you want to incentivize employees and other contributors with the company’s equity. Look at it this way: you generally want to raise money at the highest valuation possible so that you give up the smallest amount of the company possible. At the same time, you want to attract and retain the best talent by offering them equity (usually in the form of stock options) at the lowest price possible so that they choose to work with your company over a competing job offer, have a strong incentive to build value in the business, etc. For tax reasons, you can’t sell common stock to investors at one (high) price and at the same time sell (or options for) common stock at a different (low) price. This would result in very negative tax consequences to your employees. So common stock is generally not used for fundraising purposes.
Borrowing money in the form of straight debt (a loan that needs to be repaid at some point in the future) is also generally disfavored as a fundraising vehicle. First of all, investors in early-stage companies are taking a big risk. In exchange, they are hoping for a chance for a big return. They don’t simply want you to pay their money back with a little interest. Second, future investors won’t want to invest their money into the company if you are using that money to pay off earlier investors. Instead, they want you to use their money to build future value in the company.
As a result, companies will generally raise money by selling to the investors convertible debt or preferred stock. Unlike straight debt, convertible debt is a loan that won’t be paid off when the next round of funding comes in; instead, the earlier debt will be exchanged r converted into equity at the time of the closing of the next round. Learn about convertible debt. Because it is a loan that is not expected to be paid off, it doesn’t have the same disadvantages in fundraising as straight debt does. Likewise, preferred stock is used, in part, because it can be valued/priced at a higher (less dilutive) price than common stock while still allowing the company to use common stock at a lower valuation to incentivize employees and other contributors. Learn more about preferred stock.
So should you use convertible debt or preferred stock in your seed round? The answer will depend on many factors unique to you and your situation, including how much money you are raising, the type of investor investing in the company and your future fundraising plans. There are advantages and disadvantages to both structures depending on your perspective and your circumstances. There is no one size that fits all. However, in general, if you are raising a small amount of money (e.g., under $2 million) from individual investors, it is frequently the case that convertible debt will be the best structure. Conversely, selling preferred stock will often be the approach taken where you are raising more money from institutional (e.g., venture capital) investors.