WHICH SEED FINANCING INSTRUMENT IS RIGHT FOR YOUR STARTUP?
Whether it’s seed round, Series A or successive series, securing financing for a startup is an exciting, stressful and sometimes confusing process. In addition to questions involving which type of investors to seek and how much capital to raise, one of the primary decisions is what financing instrument best meets the needs of the business.
Types of Startup Financing
When most startup founders think of raising capital, they probably think of common equity. Common equity is the simple exchange of a startup’s common stock for capital. Some founders favor this type of transaction because of the inherent equality between founders and investors. Because the equity is common stock – the same equity as founders have – the idea is that investors’ goals are more closely aligned to those of the founders. The drawback to this equality is that some investors will shy away from a common equity transaction because it lacks some of the rights and privileges that later investors may demand. However, some of the same rights and privileges of a preferred stock offering can be achieved contractually in a common equity transaction if they’re absolutely required.
A slight downside to using common equity is that the market value of the company may be adversely affected, based on the price of the offering. Rarely is the market value of the company positively affected by a common equity offering because savvy investors are going to push for a discounted valuation.
“Friends and Family” Seed Round
For smaller startups looking to raise capital through a ‘friends and family’ seed round, the common equity transaction can be a good fit. Legal fees are typically lower since the required documentation is straightforward, and if the shares are already issued, then the company’s shareholder or operating agreement usually does not have to be amended. Because of the simplicity, a founder’s (typically) un-accredited friends and family should have an easy time understanding the common equity transaction, and thus be more willing to invest.
Whether a ‘friends and family’ seed round is a good idea for any company is a topic for another blog, but it’s usually an option available to almost every founder.
Another very common startup financing vehicle is convertible debt. Convertible debt is when the company issues promissory notes to investors that, at some point in the future can be converted into common company stock. The conversion price is based on the price of the stock at the time of conversion. Seed round investors are usually well versed in the use of convertible notes, so there is little risk of confusion. Similar to common stock transactions, unsophisticated investors will also usually feel comfortable with this type of financing method because of its simplicity.
One downside to convertible debt is that it creates uncertainty for investors because the percentage of company ownership at the time of conversion is unknown at the time of investment. Many founders can also be uncomfortable with convertible debt financing because the notes eventually mature, and if the investors choose not to convert (or cannot convert at maturity), then there’s the potential to force the founder to renegotiate the term of note for higher interest rates or more favorable conversion terms.
The cost of using convertible notes as a financing vehicle, similar to common stock, is lower than some other options because, until and unless the debt is converted, there is usually no need to modify the company’s corporate documents, so legal fees are lower. Another benefit to using convertible notes is that the market value of the company is not affected at the time of investment. For startups with an aggressive growth curve, this could be a significant benefit because Series A or Series B investments can be less dilutive if the market value of the company is higher.
However, convertible notes with a full rachet, anti-dilution clauses or liquidation preferences can end up costing the founder more for the capital than some other vehicles – although anti-dilution clauses are very common in a number of financing vehicles. In these cases, the anti-dilution or liquidation preferences can result in a conversion price that is drastically different than the conversion price specified in the note, and thereby cost the founder significantly more than a more conventional equity offering.
Convertible Preferred Stock
Convertible preferred stock transactions are similar to convertible notes, except that the note is converted into preferred stock which is a fixed percentage of the company at the time of the investment.
The downside of convertible preferred stock financing is that it is typically more complex from a legal standpoint because documents can be longer and more complicated than a convertible note, and is, therefore, more costly. This complexity can also limit the type of investors to accredited or sophisticated investors since they are more likely to be familiar with the variable and special terms of convertible preferred stock. Conversely, this type of transaction is more attractive to those accredited and sophisticated investors because of the certainty of equity position at the time of investment. Similarly, that same certainty is also attractive to founders because it eliminates the complicated conversion calculations at liquidation, so founders know their equity position at the time of investment as well.
Although not as significant as a common equity offering, a convertible preferred stock transaction can hurt the market value of the company at the seed round. This can impact the value of equity incentives offered to employees or others but again is not nearly as negative as common equity financing.
The preceding is obviously not meant as an exhaustive list of startup financing vehicles, but a short list of the most commonly used transactions. Founders should consider all aspects of a financing transaction, including cost, complexity, the effect on market value, certainty – both for investors and for founders, as well as how the transaction will affect existing seed investors and follow-on financing. Every situation is unique, and founders are best served to consult competent accountants, attorneys, and financing experts to determine what vehicle is best for their specific situation.