Nivi · May 14th, 2007
Summary: Convertible debt is often the best choice for a seed round. It is convenient, cheap, and quick. It lets you close the financing quickly and turn your focus back to your customers—that’s good for the company and its investors.
When your business is very young, raising a seed financing ($50K-$500K) via convertible debt is a great alternative to selling equity. Convertible debt is also known as a bridge loan since it ‘bridges’ the company to its next financing.
Convertible debt (debt for short) is not like getting a loan from a bank. A bank expects to get its loan back. With convertible debt, the lender and your company both expect to convert the debt into equity when you close the Series A. Read Yokum Taku’s series on convertible debt for a primer on this lovely financial instrument.
Seed stage debt rounds are much simpler than equity rounds, especially if your investors are angels. There isn’t a lot to hack in these agreements. You need to be more careful if you raise debt from venture capitalists, but a debt financing with a VC is still much simpler than an equity financing with a VC.
Why is debt a great alternative to equity in a seed round? Convenience, suitability, control, cost, and speed.
Debt agreements are easy to understand and hard to screw up, two great benefits if you’re raising the first financing of your life.
Compare this to a Series A term sheet which is as long as all of the closing documents for a debt round. Negotiating and closing debt is good practice for the negotiation of the 25 terms in a typical Series A term sheet.
Who knows how to determine a suitable valuation and investor rights for a seed stage company?
The company’s valuation and leverage is changing quickly as it goes from nothingness to product, users, and revenue.
The founders are unlikely to negotiate a valuation that meets their high minimum expectation since there isn’t much competition to invest in the young and risky business.
But a valuation that does meet the founder’s minimum expectations may be too high and result in a down round in the Series A. The down round leaves the founders feeling like they lost money even though the company made progress, the angels feeling like they took risk but got squashed, and the Series A investors feeling like they are dealing with unsophisticated operators.
Finally, it’s tough to reach a high Series A valuation soon after setting a low or moderate valuation in a seed round. Your Series A investors won’t want to pay a much higher share price than seed investors who bought stock just a few months ago.
Founders usually continue to control a company after a debt round.
They control a majority, or all, of the board seats. Debt investors, especially angels, don’t necessarily want board seats. Seed stage equity investors, especially venture capitalists, often do. Controlling the board reduces the burden of reporting to the board and diminishes the likelihood of disagreements between the board and management.
The founders also control a majority of the company’s common stock. There is no preferred stock. They can sell the company for $10M, give $2M to the debt investors, and take home $8M. Try doing that with equity investors who have preferred stock with protective provisions that allow them to veto a sale of the company. In particular, venture capitalists often have big funds and they’re looking for big returns, not $10M exits.
Finally, if you raise debt, you can create and run a profitable business that doesn’t need an ‘exit’. Angels may be happy getting a big dividend from your company every quarter, whether they bought debt or equity. Venture capitalists aren’t looking for a quarterly dividend—they need to sell or IPO a company to return a profit to their investors (their limited partners). Raising debt from VCs maintains the option of building a ‘non-exiting’ business—you can always pay their debt back when it comes due. That said, we don’t recommend taking debt from VCs with the plan of building a ‘non-exiting’ business—that’s disingenuous.
You can negotiate a debt term sheet and close the money for under $10K in legal fees. There are very few terms for the lawyers to discuss—they will barely have to modify their boilerplate documents.
Negotiating a Series A term sheet and closing it can cost $20K-$60K in legal fees. Why would you or your investors want to spend that much money on legal fees when you’re raising a $100K seed round?
Once your investors are ready to talk terms, you can negotiate a term sheet in one week and close the deal one week after that. The documents are short and simple—there isn’t much to discuss. Compare this to an equity financing which can take two weeks to negotiate and 4-6 weeks to close.
Debt is often the best choice for seed rounds.
Convertible debt is often the best instrument for a seed round. You can close the debt cheaply and quickly and then turn your focus back to your customers. That’s good for the company and its investors since speed is a major competitive advantage of a startup. If you or your investors are veering away from convenience, low cost, and speed, you are missing the point of seed stage debt!
The seed stage is the worst possible time for the founders to negotiate an equity financing. The company is nebulous, the founders are inexperienced, and the company is starved for cash and time. The team should be testing hypotheses about their business, not negotiating complicated term sheets.
Investors who market themselves as ‘business partners’ should agree that they can add a lot of value to the business by doing the financing quickly and letting the team get back to their customers.
What do you think about the benefits of debt vs. equity?
Use the comments to share your thoughts and questions on the benefits of debt vs. equity. We’ll discuss the most interesting comments in a future article.
Our next convertible debt hack shows you how to compare the economics of debt vs. equity.