Summary: Seed investors often argue that debt doesn’t incent them to (1) help the business and (2) increase the share price of the eventual Series A. Actually, (1) debt does incent investors to help the business and (2) equity may also incent investors to decrease the Series A share price. That said, you can make your debt much more attractive to investors with a few concessions.

Although convertible debt is often the best choice for a seed round, investors often argue that debt does not incent them to contribute to the business:

If I buy debt and contribute to the business, the share price of the eventual Series A goes up and the number of shares I get for my debt goes down. Debt doesn't incent me to help the business and increase the price of the Series A.

Debt holders are incented to help the business.

Your response to an investor’s claim that “(1) debt doesn’t incent me to help the business”:

“If you buy $100K of debt, you get $100K worth of shares in the Series A, plus some shares for your discount. You’re not losing money by contributing to the business—the Series A share price may go up but your share value remains $100K, plus a discount.

“And… as you contribute to the business, the company’s risk goes down, opportunity goes up, and the net present value of your debt goes up. You’re still incented to help the business when you buy debt.”

That said, equity incents an investor even more. If an investor buys $100K of equity in the seed round and locks in his share price, he makes a paper profit if the share price increases in the Series A.

Note to entrepreneur: You don’t need to make this argument on your investor’s behalf.

Equity holders are also incented to decrease the Series A valuation.

Your response to an investor’s claim that “(2) debt doesn’t incent me to increase the eventual share price of the Series A”:

Rational investors are

  1. Insensitive to the next round’s price if they plan to maintain their percent ownership,
  2. Incented to increase the next round’s price if they plan to decrease their percent ownership, and
  3. Incented to decrease the next round’s price if they plan to increase their percent ownership.

(We’ll explain how the math works in the comments.)

Some seed stage funds maintain or decrease their percent ownership in the Series A. These funds tend to focus on seed stage companies.

Other seed investors try to increase their percent ownership in the Series A—if the company is doing well. These funds tend to invest in most stages of a company’s growth.

Ask your investors about their track record and strategy for follow-on investments. If they like to increase their percent ownership in their best investments, they have an incentive to drive down your Series A valuation whether they buy debt or equity in the seed round.

Make your debt attractive to investors.

Rather than debating the finer points of your investor’s incentives, you can make your debt much more attractive to investors with a few concessions (ordered from small to large):

  1. Don’t let the company pre-pay the debt. Your investors don’t want you to repay the debt just before you raise a Series A or sell the company.
  2. Anticipate a potential sale before the Series A and negotiate your investor’s share of the sale price. Your debt investors want to make money if you sell the company before the Series A.
  3. Increase the discount by a fixed amount and/or 2.5% per month, up to a maximum that can range from 20% to 40%. A higher discount yields a higher return for your investors. For example, a 40% discount guarantees your investors a 1.7x return on paper when the Series A closes.
  4. Set a maximum conversion price for the debt.
    The debt could convert at the lesser of (1) $X/share and (2) the actual Series A share price. This cap effectively sets a maximum valuation for your debt investors and protects them from a high Series A share price. This is a great way to maintain the benefits of convertible debt while rewarding your debt investors for investing early. The maximum conversion price can be significantly higher than any valuation you could negotiate easily.

How have you made debt attractive to investors?

Use the comments to share your experiences and questions on making debt attractive to investors. We’ll discuss the most interesting comments in a future article.

Topics Convertible Debt · M&A · Valuation

26 comments · Show

  • Nivi

    In the article, we said that we would explain why rational investors are insensitive to the next round’s price if they plan to maintain their percent ownership. Here we go…

    Let’s assume the amount of new money being raised is fixed, say $10M. Let’s also assume I’m an investor who owns 25% of the company before the new money comes in, i.e. I own 25% of the pre-money.

    1. If I want to maintain my 25% ownership, I need to invest 25% ($2.5M) of the new money coming into the company. I’m insensitive to the pre-money because I already own 25% of the pre-money.

    2. If I want to decrease my percent ownership, I need to invest less than 25% of the new money coming in. Let’s say I invest 5% of the new money. I own 25% of the pre-money but only 5% of the new money. So I want the pre-money to be as big as possible to increase my percent of the post-money. Remember,

    post-money = pre-money + new money

    3. If I want to increase my percent ownership, I need to invest more than 25% of the new money coming in. Let’s say I invest 75% of the new money. I own 25% of the pre-money but 75% of the new money. So I want the pre-money to be as small as possible to increase my percent of the post-money.

    Finally, although investors are mathematically insensitive to the next round’s price if they want to maintain their percent ownership, they are still incented to chase a high valuation. A high valuation lets the common stockholders keep a lot of the company and keeps them highly incented to make money for themselves and the preferred shareholders.

  • NotSure

    Hi,

    I run a new startup that is still in development. Currently we have no seed capital or investment and its getting tougher to expand development as I am footing all the bills.

    I study part-time, work-part time and the rest of my time is spent on the startup.

    Seed funding would allow us to work full time on the startup – but being Australian based – it is extremely difficult to get in contact with investors that would be willing to listen to our idea (Australia has a terrible funding environment).

    We have contacted some US VC’s who are interested in what we are doing but because “we arent based there” they knock us back.

    What do you think is the best strategy to take in this regard?

    • Yokum Taku

      Not Sure,

      You might want to try to touch base with Ben Keighran and the team at Bluepulse. They moved from Sydney to the Silicon Valley in order to secure their Series A financing. They faced the same challenges that you are facing.

  • JTreiber

    Very interesting post. I think the one thing to distinguish here is whether you are raising debt from “smart” money (i.e. VCs or Angels) or from friends and family. As most people know, friends and family tend to be less hard-nosed about terms and the mechanics. As entrepreneurs, we have a responsibility to explain the documentation to all investors so that there aren’t any tricks.

    We raised our seed round with convertible debt from friends and family. The terms were straight-forward and we didn’t have to make any real concessions. We did the deal with a 10% coupon (equal to a 10% conversion discount if security held for 12 months) which is paid in stock at the Series A. Based on what I’m hearing, we got a pretty good deal. However, we lost a few other potential investors who wanted better terms with a real conversion discount at 40%. In the end, we probably left about $200-$300k on the table by sticking to our original terms. The bottom line for us was that non-friends/family wanted better terms to protect their investment. Friends and family were happy with the basic terms to help us out and participate in any upside. We call this type of capital “love capital” and it’s probably some of the cheapest around. Definitely look for it if it’s available.

  • Pseudotim

    Nivi.. regarding the methods for making your debt more attractive to investors, it seems that option 4… setting a maximum conversion price for the debt, is essentially a valuation discussion. If one of the major benefits of convertible debt is avoiding the valuation discussion, doesn’t this provision open that issue back up? If you going to go back and add something like this into the convertible debt, aren’t you just that many steps closer to the hassles of a series A?

    And in terms of actual investor behavior, isn’t the greatest risk for an investor, the company not suceeding? Isn’t an investor, even in a convertible debt scenario, going to do everything they can to see the company be successful, because it is better to have a smaller part of something that is a win, vs. a big part of a loss? Are investors so calculating as to ration their contributions, so a company can be successful, but not too successful? Or is this primarily a dynamic that comes into play when series A valuation is being discussed?

    • Nivi

      Pseudotim,

      There are lots of benefits to doing convertible debt. Avoiding a valuation discussion is one of them.

      I’ve never negotiated a cap but I think it lets you change the discussion from valuation today to a maximum conversion price in the future. Your investors should be able to stretch to the high end of their valuation range, especially combined with a discount. You can say, “We just want to make sure you are protected in the case that the Series A valuation is very high. And it gives you an incentive to increase the Series A valuation.”

      “And in terms of actual investor behavior, isn’t the greatest risk for an investor, the company not suceeding?”

      You make a great point. That said, put yourself in the investor’s shoes who has a lot of investments where he needs to spread his time. He is going to spend his time wherever his highest returns are. Debt can lower the returns of the investor. They are incented to help the business if they have debt but they are incented even more if they have equity.

  • Nivi

    paul left a comment on Y Combinator Startup News:

    “I’m still not buying unless a valuation is attached (his option four). Here is my reasoning:

    Many startups are interested in using a convertible note for their early funding. I’ve heard three reasons:

    1. It’s less paperwork than preferred stock

    2. VCs would rather do a Series-A than a Series-B (one solution is to name this first round “Series-Seed”)

    3. It lets them avoid having to determine a valuation

    The first two reasons seem fine to me, assuming that they are true. The third reason is bad.

    These convertible notes typically convert into preferred stock upon the next major financing (presumably the Series-A led by some VC), usually at some discount to what the VC pays (perhaps 20%). Sometimes there is a cap on this conversion price. If that cap would be a reasonable pre-money valuation today, then third reason doesn’t really apply, since a valuation was in fact determined.

    However, if there is no cap on the conversion price, or that cap is very high, then you are asking investors to give you money today, but not giving them the upside between now and then next major funding (which probably won’t occur for another 6 – 12 months). During this 6-12 months you will build and hopefully launch a product and begin to prove it’s market potential, or not. That’s a lot of uncertainty.

    Put another way, I’d rather wait 6-12 months to see what you build, how successful it is, and how well your team executes, and then decide whether or not to invest. And I’d gladly pay an extra 30%. However, if you need the money today, then it needs to be at today’s valuation, not next year’s.”

    • Nivi

      My response to Paul’s comment:

      Hi Paul,

      There are lots of benefits to doing debt in a seed round.

      A cap doesn’t determine a valuation. It just sets a cap. Setting a valuation implies buying preferred stock, I assume you don’t want to buy common stock in the business. That means negotiating investor rights–that is a pain in the ass. (I’ve never seen this but I suppose you could defer negotiating investor rights and just say that the seed investors will get the same rights as the eventual Series A investors. Anybody want to chime in?)

      A cap can be closer to the founder’s high minimum expectations and avoids a long road show. A cap avoids setting a high valuation and then doing a down round in the Series A. A cap avoids setting a low valuation and then being unable to substantially increase the valuation if you do a Series A soon afterward.

      If you want more of a reward, we suggested increasing the discount. A 50% discount guarantees you a 2x paper return on your money. A 40% discount guarantees a 1.7x paper return. You can also have the discount increase over time.

      As always, our hacks are generalized and should be tailored to the specific circumstances. And your deal is mainly determined by your leverage, nothing else: e.g. every deal that closes is a “good deal”.

      • Yokum Taku

        Nivi,

        I’ve done early angel preferred stock financings where the angel Series A only had a liquidation preference and there was a contractual provision that forced to company to give the angel Series A all other investor rights that would eventually be given to the “real” Series B (adjusted for price-related terms). The Series B may have issues with giving the Series A the same level of rights, so the Series B may condition the Series B financing on the Series A rights being something they can live with.

  • Suzie Dingwall Williams(Venture Law Lines)

    There’s an interesting alternative attracting high net worth investors here in Canada: using a limited partnership to invest in the startup. A portion of the operating losses are then flowed back annually to the limited partners while the company builds. No control or debt issues. Plus, the company has a drag along right which can be used to either sell the company or to convert the partnership structure into a regular share like investment at certain triggers in the future. Nothing new or fancy here; but it does make high risk investing appealing to a different set of investors, which is important when your startup is off the grid.

  • vs

    Hi,

    Sorry for posting here, I am a first time entrepreuner and learning all of this. if there is a company decision the management agrees (with the ceo) and the founder does not. I proposed let us go to the board for the decision. how does the board decide? we have one indepnedent board member, two investor and two founders all on the board.

    Is it how many people vote for against the founder? what happens to the founders if we dont get the vote? or ceo/ management if the board thinks is not making sense?

    Thanks,

  • Eric Deeds

    I really like what you’re doing here. A few thoughts on the seed round structure debate.

    First, don’t underestimate the benefit of simplicity, convertible debt is a lot cheaper and quicker to put in place than an equity structure, even with dumbed down seed / angel terms. Also, if you’re raising the money $50-100k at a time, you don’t really have one person to negotiate terms with, so the fewer terms the better.

    @ Paul regarding valuation vs. no valuation, don’t forget one benefit angels are getting either way is access to the company. The door is typically shut at Series A. I don’t think it makes sense as an angel to push too hard to put a price on the company at the seed round. For one thing, its possible (and not entirely uncommon) to overpay, which is awkward for the company and the angels. A risk premium to the Series A in the 10-40% range should be adequate compensation.

    I think complex discount / cap structures can be more trouble than they’re worth. As noted, at the extreme you are pricing the company, they complicate and increase the cost of putting the round in place, and based on some experience, VCs just seem to hate paying more for a Series A share than the seed investors. Warrant coverage provides the same risk premium with a lot less friction.

  • me

    Why do you have a picture of a kid with a head knocker? That doesn’t sit well with me.

  • J Lyons

    Much of the discussion has focused on providing the note holders a discount to the series A price when it converts. Curious if people have a view on what “market” is in terms of the discount amount?

    Also, the other structure I’m aware of is providing warrant coverage as incentive for investing in the convertible note (i.e. the option of the convert holders to purchase a particular percentage of their original investment in additional series A).

    What are the relative trade-offs between the two structures? It seems to me that the warrant approach eliminates the risk the series A investors will try to have the company re-negotiate the terms with the convert holders.

    • Nivi

      In my experience, most discounts are between 20%-40%. It can go up to 50% at times.

      I don’t agree with this common meme:

      “series A investors will try to have the company re-negotiate the terms with the convert holders.”

      It is the entrepreneurs who end up not liking the deal they struck with angels. It is the entrepreneurs who want to renegotiate with the angels.

      Why should the VCs care? From the VC’s perspective, the entrepreneurs can just eat the dilution.

      The caveat here is that the VCs want the entrepreneur to be motivated (e.g. own a good chunk) and one way for the entrepreneur to increase his chunk without decreasing the VC’s chunk is to take it out of the angel’s ass.

  • songpeace

    I posted this earlier but it seemed to disappear.

    What are the pros and con’s of warrants vs discounts on the A series. Right now we are raising $250K in a bridge and they only asked for 100% in warrants and no discount on the Series A.

    I would think that the discount would be better for the company and the holders of the common stock as the warrants would dilute the common.

    Any thoughts on how to handle the this?

  • chamonix

    I realize this thread is quite stale, but I was trying to find out if anyone’s done a “convertible notes + valuation cap”? I’m especially curious 1) how it was received, and 2) how subsequent investors viewed the prior arrangement.

    Great stuff on here, guys.

    Thanks!

    • Nivi

      I have done it. Lots of angel investors won’t do debt without a cap.

      • chamonix

        Nivi,
        Thanks for responding…

        It seems as though the follow-on investors (let’s say the investors doing the ‘A’ round after the seed) would not be too happy about having the seed investors converting in at a substantial discount (say the $0.5M seed was capped at $2M and the A is $3M on $5M pre) with the same rights & privileges. Does this indeed create angst and additional difficulty with the next round? Of course my company will be doing so well by then it won’t matter, but just hypothetically… ;-)

        • Nivi

          In your example, how would things be different if the seed round was structured as equity?

          In either case, you need to raise enough money in the seed round to achieve some milestones that raise your valuation for the A round.

          • Chamonix

            Thanks again for the reply Nivi, this is really helpful.

            The difference is with regards to the myriad other terms a second-equity-round investors would ask. In the convert-w/a-cap example, the seed investors would invest alongside the “A” investors with the same rights & privileges, albeit at a massive discount (the valuation gap + any warrant coverage)

            In the small-equity example, the seed investors would have their own terms, normally (in my understanding) superior to the previous equity round.

            Thanks again for all the info.

  • Andres

    Great post and comments. My question: what are typical caps you may have seen for social media companies raising ~$500K in Silicon Valley (or beyond)?