Seed Investing: Understanding the Landscape - Part II

• 1.20.2016

In this second post of our three-part blog series on the different types of seed instruments we will explore Series Seed. 

Series Seed documents were introduced by startup lawyer Ted Wang and venture capital firm Andreessen Horowitz as a standard for priced seed rounds. They intended to reduce the cost and time of seed investments, while at the same time providing fair and reasonable terms for both the investor and the founders.

Before the introduction of Series Seed, companies used full-blown Series A documents for preferred stock issued in a priced round. In a Series A financing, the investors, as preferred stockholders, typically get preferential treatment over common stockholders with respect to payment of dividends, amounts distributed in case of liquidation, voting rights, anti-dilution protections and/or redemption.

Series Seed documents introduced a trimmed-down version of the Series A preferred stock terms and imposed fewer restrictions on the day-to-day operations of the company. Unlike Series A documents, Series Seed documents do not include preferential dividends, redemption rights, anti-dilution protections (although some investors ask for them to be included) and registration rights. Series Seed documents also have more lightweight protective provisions, information rights, and representations and warranties than Series A documents. Since the investors come in at a valuation (unlike in a convertible note), a company using Series Seed documents has to make sure that the option pool is set up, since the pre-money valuation will also take into account an option pool.

Pros of Series Seed

1. Efficiency and cost reduction. Series Seed documents have cut the cost of financing by reducing the number of documents involved. The standard terms serve as a fill-in-the-blank, which limits the need to negotiate and makes the process quicker. Series Seed also introduced a standard legal cost—$10,000—so no surprises with the legal bill at the end of the round.
    
2. Pro-founder terms. The Series Seed documents come with a standard 1X non-participating liquidation preference, which is the most founder friendly of the liquidation preferences. They also did away with terms like anti-dilution that are not relevant at the early seed-stage funding.
   
   
3. Set valuation and aligned interest. Since a Series Seed financing is a priced round, investors and founders have to agree upon a valuation. This agreement provides certainty as far as stockholding, dilution in future rounds and liquidation preferences go.
   
   One of the often discussed “pros” of convertible notes is that they do not require any valuation discussions but with “caps” on convertible notes becoming more and more common, notes are also effectively setting a “maximum valuation for noteholders. While the Series Seed priced round sets a specific valuation, capped notes don’t downside protection for founders.
   
   In the case of uncapped notes, the interests of the founders and noteholders are not always aligned—it is in the founder’s interest to maximize the valuation of the company at the time of the next financing in order to minimize the resulting dilution. Noteholders, on the other hand, seek to minimize the valuation of the company so that the principal and interest under the notes convert into as many shares of preferred stock as possible. If the company gets a very high valuation, noteholders could wind up owning a much lower percentage of the company than they originally anticipated.
   
   
4. Long-term capital gains. From the investor perspective, a priced Series Seed means that the long-term capital gains tax clock starts ticking from the time of issuance of the stock, If the founders issue convertible notes, on the other hand, the clock starts when the debt converts to shares.

Cons of Series Seed

1. Limited use. Since its introduction, Series Seed documents have been used in several investments, usually when both the valuations and investment amounts are low. Beyond a certain threshold (usually, a $1 million investment and a valuation of $3-$4 million), the investors are more interested in the bells and whistles that come with a Series A investment.
   
   
2. Investor control rights. Investors usually get a board seat and veto rights for certain corporate actions in Series Seed documents. Founders should consider whether this is a right that they want to give up for financing below a certain threshold. That said, investors may be willing to negotiate these rights, but the negotiations will add time and money to the financing.
   
   
3. Term creep. Just as products suffer from “feature creep,” Series Seed documents have created a trend toward “term creep”—parties want to start with Series Seed, but change the terms in the term sheet. The resulting “hybrid Series Seed” documents are growing to resemble Series A documents more and more, which means that the advantages of using standard documents apply less and less.
   
   The most favored nation (MFN) clause is often one of the changes made to the standard documents. With the MFN clause, Series Seed investors get the same rights as investors in the next round of financing, with a few adjustments for economic terms. Although this clause may reduce negotiation and keep documents trimmer at the seed stage, it also means that the entrepreneur is not only giving up equity at a lower valuation but is also not getting the founder-friendly terms.
   
   
4. Kicking costs down the road. Although a company will likely save by using Series Seed documents at the seed stage, its legal bills for the Series A financing will be much higher because the Series A Certification of Incorporation will need to be amended and restated. The provisions missing from Series Seed (e.g., registration rights) that are standard in Series A will also have to be added to the Investor Rights Agreement. Lawyers will have to spend time (and the company’s money) comparing documents and adding all the rights from the Series Seed to the Series A, which will take even longer if the Series Seed terms aren’t completely standard.
   
   Of course, this extra cost only becomes a concern when a company goes on to raise a Series A round. Some companies might decide to save at the seed stage and pay more later when they have more money in the bank.

In case you missed it, read Part I on convertible debt. Stay tuned for Part III next week.