Seed Investing: Understanding the Landscape - Part I

• 1.13.2016

Starting a company has never been easier. Technology solutions for payroll, accounting, cloud computing and payment systems have made it much cheaper to take care of the back end.

But founders may start seeing more expenses when they hit the fundraising process, some of which come from legal fees. Fortunately for entrepreneurs, several lawyers and investors have tried to cut down these expenses by providing standard documents for seed-stage investing. Unfortunately for entrepreneurs, as more and more new types of instruments and investment documents are introduced, it becomes difficult to distinguish between them or even understand which one is the best option.

In this three-part blog series, we will explain the different types of seed instruments: Convertible Debt, Series Seed and SAFE.

Convertible Debt

Seed-stage investments are often structured as convertible loans. Investors loan money to the company and, in exchange, receive convertible promissory notes. The notes then convert at a specified milestone, usually when the company sells preferred stock in its next financing, into shares of that same series of preferred stock. Occasionally, the notes automatically convert at the maturity date at a pre-determined price.

Discounts and caps

The notes 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.

Over the last few years, as the size of seed and downstream Series A rounds have increased, investors have introduced a cap on convertible notes. For example, if the notes have a cap of $4 million and the company raises a Series A at a pre-money valuation of $8 million (assuming the conversion is based on pre-money valuation), the noteholders will convert the principal amount and the interest at an effective price of $4 million, i.e., 50 cents for each dollar given by the Series A investors.

The company and investors often negotiate whether or not a cap is appropriate, if so what the cap should be and whether the note investors should share the dilution resulting from an new option pool created as part of the Series A round.

From the company’s perspective, it is better not to have a valuation cap, because although it offers the investor down-side protection, it has no benefit to the company and can be highly dilutive to the founders.  From an investor’s perspective, receiving a note without a cap means taking the risk that the next round is at an unexpectedly high valuation—reducing the relative benefit of the discount. 

When notes include both a discount and a cap, they usually convert at the lower of either the price per share based on the discount to the Series A or the price per share determined by dividing the cap by the pre- or post-money valuation of the Series A (usually the pre-money). It is always worth clarifying this up front so that founders understand the dilution in subsequent rounds.

Maturity Date

At the end of the day, the convertible note is a loan and has a maturity date, i.e., the date on which the principal amount and the interest become due and payable to the investor, if the loan has not yet converted. The maturity date varies between 12 and 24 months from when the loan is granted, with 18 months being the most common.

Other features of the “notes” aspect of convertible notes include interest rate (generally between 1% to 4%) and repayment terms.

Pros of Convertible Notes  

1. Efficiency and cost. A convertible debt financing requires fewer and less complicated documents, so a company can complete it more quickly and cheaply than a preferred stock financing. This is particularly important in a seed round, when the company might not raise a significant amount.
   
   However, since the investment community has widely begun to accept other standard documents, this may not remain an advantage exclusive to convertible notes.
   
   
2. No current valuation. Selling preferred stock requires a company and its investors to agree upon the current value of the company. This task can prove difficult for early-stage companies, especially if investors lack experience or if founders feel that the company is not mature enough for investors to value it fairly. With convertible debt, the company and investors generally do not need to agree upon the company’s current valuation. Instead, they defer the valuation decision until the time of the next preferred stock financing. That said, a cap on the notes is effectively a valuation for the noteholders; the no current valuation only holds true in an uncapped note.
   
   
3. No investor board seat or control provisions. Noteholders rarely if ever get board seats or veto or control rights. This allows founders to retain control of the company without assigning board seats to someone that may end up owning a relatively small percentage of the company.
   
   Although this is a definite advantage of convertible notes over other forms of seed investing, founders should remember that board and control provisions are usually negotiable even in priced seed rounds.
   
   
4. Fundraising flexibility. Founders often use notes with different caps to raise funds over an extended period of time. Since a cap is not a valuation for tax purposes, founders can effectively leave the note round open for a longer period and close it on a rolling basis. Sometimes, it also eliminates the need to have a lead investor in the round.
   
   On the flip side, fundraising can be a very time-consuming process, and founders may want to close the round and move back to focusing on the product and company. Also, even in a seed-priced round, a founder could negotiate to leave some room for friendly investors to join the round in the near future, usually between three to six months, at the same valuation.
   
   
5. No impact on common stock. Selling common stock for fundraising purposes has the effect of fixing the current fair market value of the company’s common stock. As a result, a company can no longer issue equity incentives to potential employees (in the form of options to purchase shares of common stock) at a price below the common stock sold for fundraising purposes without creating negative tax and accounting issues. Issuing convertible debt without a cap does not create those same concerns for the value of the common stock.

Cons of Convertible Notes  

1. Additional dilution. A note with caps means an investor pays a fraction of the full price for shares issued in the equity financing. Let’s use the example of notes with a $4 million cap and a subsequent Series A with $8 million pre-money valuation. The convertible noteholder received a share worth a dollar but only paid 50 cents, so the dilution resulting from the convertible debt was twice that resulting from the new money invested in the financing round.
   
   
2. The hidden liquidation windfall. This is where most founders are caught off guard. While they are prepared to negotiate a 1X non-participating liquidation preference common in a Series A or subsequent funding round, they do not realize that the cap on the notes gives the noteholders a multiple liquidation preference.
   
   In our example above, if noteholders invested $100,000, they would get 200,000 shares (assuming price of a dollar  per share in Series A). Even if the founders negotiate the terms of Series A financing to be a 1X non-participating liquidation preference, the noteholders will still get a 2X liquidation preference on their investment, i.e., $200,000 (200,000 shares times $1). This doesn’t even account for the interest.
   
   Some investors reason that this return is only fair, considering the risk that they took in investing at an early stage.
   
   
3. Maturity date as the ticking clock. As mentioned above, the convertible note comes with a maturity date. If the company has not raised its Series A by that time, the noteholders can potentially call for the notes to be repaid, which would pass the leverage back to the investors.
   
   In most cases, however, the investors will amend the notes and extend the maturity date. Calling the note in could potentially bankrupt the company, while extending the deadline gives the noteholder an opportunity to participate in the upside by giving the company more time to reach its milestones.

Fixing the Liquidation Windfall  

1. Price the round. One of the main advantages of notes is not having to value the company. Since caps effectively do set the valuation, founders may want to consider moving to a priced seed round without giving up board or voting control.
   
   
2. Convert the discount to common stock. In some cases, founders can negotiate for convertible notes to convert to the preferred stock in the next round of financing so that the liquidation preference matches the dollars invested, and the balance of the shares convert to common stock. This keeps the cap table clean, but it also means that the founders now have other common stock holders with the same voting rights.
   
   
3. Convert notes to shadow preferred stock. More commonly, companies have started to create a shadow preferred series, e.g., Series A-1, Series A-2, etc., so that the notes convert into their own class with a 1X liquidation preference to match the dollars invested. The other rights of investors in these shadow preferred series are the same as the preferred stock holders; they even vote as a single class.
   
   Some founders shy away from this solution because of the complexity that it adds to the cap table, but it also has advantages: (i) it can protect the founders from entering a situation in which the noteholders have a multiple liquidation preference, and (ii) seasoned investors do understand how cap tables, even complicated ones, work.
   
   A potential risk to this method is that the shadow preferred stock will have a separate class vote under Delaware law for actions that disproportionately and adversely affect that series, potentially giving the former noteholders the ability to block certain actions that the company wants to take.
   
   The only times that creating shadow preferred stock may not make sense is if the difference between the cap and the valuation in the subsequent priced round is not very big, and the company chooses to ignore the excess liquidation preference. This is why, usually, the creation of the shadow preferred stock is left to the option of the founders.

Stay tuned for part two of this three-part blog post—we’ll take a look at series seed funding. And for more about convertible notes, check out this video.

• Part II covers Series Seed
• Part III covers the Simple Agreement for Future Equity (safe)