Should a startup company raise its seed round using a convertible note or Series A Preferred Stock?

April 27, 2007

I’ve noticed some interesting posts on the subject by Brad Feld, Josh Kopelman, Jeff Clavier, Dick Costolo, and Education Revolution, among others. In addition, there seemed to be a lot commentary (such as from Fred Wilson) about Charles River Ventures QuickStart Program that involves a seed financing with a convertible note with an increasing (but capped) discount over time.

Generally speaking, I think that the founders of a startup company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A, the valuation is probably going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People good at excel should try to model the different scenarios.  Venture Hacks has a good article about the math involved in this modeling exercise.

2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A. However, this is not always the case.

That being said, I think that there are two principal reasons to dislike convertible debt from the founders’ perspective.

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A to be low, so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.

2.  Investors may request aggressive terms.  For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc.  In a Series A financing, there seem to be some established norms on what is typical.  In a convertible note bridge financing, creative investors may suggest some unusual terms.

I will run through the nuts and bolts of a sample convertible note bridge financing term sheet in the next series of posts.

Comments

  • http://venturehacks.com Nivi

    One way to mitigate the debt investor’s perverse incentive to lower the valuation of the Series A is to put a cap on the debt investor’s Series A share price.

  • http://www.startupcompanylawyer.com Yokum

    Hmm … interesting thought, but never actually seen it done as a practical matter. I’m not sure whether an investor would ever agree to saying something like “the note is only convertible into the Series A Preferred Stock if the pre-money valuation is greater than $X, otherwise you simply get repaid principal plus some amount of interest.” That seems to disincentivize the investor from investing, plus now you have the hassle of negotiating $X. I’ll ponder some alternatives.

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  • http://venturehacks.com Nivi

    Yokum, I meant that the debt investor would pay the lesser of (1) the cap and (2) the actual Series A share price.

  • http://www.startupcompanylawyer.com Yokum

    I’ve never seen a conversion price written as the lesser of (1) [insert pre-negotiated valuation]/[fully-diluted shares at Qualified Equity Financing], or (2) the price per share in the Qualified Equity Financing. That doesn’t mean it can’t be done. I suppose this would eliminate the incentive of the investor to drive the eventual Series A valuation down. The primary problem will be determining the pre-negotiated valuation. The point of the convertible note is to avoid the valuation discussion at the time the note is issued. I think that the hassle of determining the pre-negotiated valuation is greater than the investor incentive issue.

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  • Cheryl’s Desk

    I would not use a convertible note as my first choice of financing. As mentioned above the debt investors are not interested in seeing the value of the company increase. Getting them to place a cap on their value in the Series A is not something any smart investor would agree to. Your best bet is to get an investor to accept a valuation for shares and have them work with you to help increase the value of the company.

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  • http://www.summitlaw.com Charlie

    In my opinion, a convertible note that converts at the lesser of (a) an agreed pre-money valuation or (b) [an agreed discount to] the next round price works well for both the company/founders and the investor. From the investor’s perspective it both caps the conversion valuation (a primpary objection to convertible notes) and lets the investor piggyback on the negotation power of larger investors in a valued round. From the company’s perspective, it allows it to raise capital quickly and cheaply. Even a “stripped down” Series A (i.e. no reg. rights, limited reps and warranties in the stock purchase agreement, etc.) can cost $15k -$20k or more in legal fees. If the convertible note also lets the investor convert to equity (probably common stock) before a sale and at maturity at an agreed upon valuation, it seems the best of all world for investors. But, in my experience many angel investors (at least in Seattle) seem to have a knee-jerk negative reaction to convertible notes (probably because they assume valuation cannot be capped) so it’s a more difficult sell for the founders than equity.

  • http://www.AngelBlog.net Basil Peters

    I agree that a convertible note is preferrable to a preferred share, but there is an even better way. The convertible note structure is never fair to the angel investors. A much better structure, that retains the benefits, but has none of the disadvantages is the exchangeable share. I outline the benefits and the mechanics at http://www.angelblog.net. I hope this is helpful. Basil

  • Ne_usa1

    I invested $30K in a company and got preferred stocks.  Now, they are transitioning from a Sub S to LLC and they want to substitute a Promissory Note for the Preferred Stocks.  All other terms are similar.  Should we agree?  If not, why not?