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You generally have four different options for how to structure your seed financing: common stock, debt, convertible debt and preferred stock. 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.
Seed-stage investments are often structured as convertible loans. Investors loan money to the company. In exchange, the investors receive convertible promissory notes. When the company later sells preferred stock in its next financing, the loan will automatically convert into shares of that same series of preferred stock. The notes would typically convert at a discount (generally between 10% to 20%), so the seed investors would receive their shares of preferred stock at a better price in recognition of the fact that they took an earlier and bigger risk on the company as compared to the new investors in the preferred stock financing.
Common stock is so named because it is just that—common. Common stock isn’t generally accompanied by any special rights, preferences or privileges; it lacks the bells and whistles that are usually attached to preferred stock that give it the “preferred” status. Shares of common stock typically give the holder the right to vote on matters presented to the shareholders of the company and the right to receive proceeds upon the dissolution or sale of the company after the holders of preferred stock are paid any “preferential” or senior amounts. Common stock is typically issued to the founders of the company and to other employees, consultants, advisors and directors who receive grants of common stock or options to purchase shares of common stock.
The “liquidation preference” is the amount of proceeds from a sale or liquidation of the company that the preferred shareholders will receive before the common shareholders are entitled to receive anything.
Term sheets for venture capital financings include detailed provisions describing the terms of the preferred stock being issued to investors. Some terms are more important than others. The following brief description of certain material terms divides them into two categories: economic terms and control rights.
Whether a company should agree to a valuation cap in a convertible note will depend on its particular circumstances. From the company’s perspective, it is better to exclude a valuation cap, because it offers the investor down-side protection but has no benefit to the company. However, it may not be possible to exclude the cap if the investors condition their investment on including a cap and the company needs the money to fund its operations. Before making a decision, a company should consider the pros and cons of agreeing to a valuation cap.
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