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.

1. Convenience

Debt agreements are easy to understand and hard to screw up, two great benefits if you’re raising the first financing of your life.

A debt term sheet is no longer than one or two pages and the closing documents are no longer than ten pages. There aren’t many terms to negotiate in a debt agreement.

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.

2. Suitability

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.

Raising debt avoids setting a valuation, delays negotiating detailed investor rights, avoids the option pool shuffle, and gives the seed stage investors an upside through a discount and/or warrants.

3. Control

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.

4. Cost

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?

You can further reduce your legal fees by reading our convertible debt hacks and Yokum’s convertible debt articles while you work with your lawyers. (Venture Hacks is not legal advice!)

5. Speed

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.

Thanks to Brian Norgard, Zach Coelius, and many others for suggesting this article. And apologies to “ds” for stealing a little bit of his language.

Topics Board of Directors · Convertible Debt · Valuation

19 comments · Show

  • Dharmesh Shah

    Great article.

    Having been on both sides of the fence (entrepreneur and investor), I’d add one more important point:

    One down-side to the convertible note is that there is a potential misalignment of interests.

    Example: Let’s say I take seed investment from an investor as a convertible note (for all the reasons stated). The potential problem is that at least in theory the investor is now working against her economic interests when trying to raise the value of the company. The reason is that once the valuation is established at the Series A, the price the investor pays is a discount from the Series A valuation.

    By some magic, if the investor has the ability to help me get a major improvement in valuation (going to $8MM in pre-money, let’s say), then with a 20% discount, she’s going to effectively pay $7.4MM as the pre-money valuation. Seems hardly fair given that she came in so early and helped get company get to the next milestone.

    Basically, the downside is that because the price fluctuates, convertible note investors are helping increase their own price.

    This is not usually a major impediment (and small compared to the other advantages), but the nuance is worth considering.

    • Nivi

      Thanks Dharmesh. We’re going to address investor concerns in a future convertible debt hack.

      In the meantime, the easiest solution to your dilemma is to put a cap on the conversion price of the debt. This sets an effective maximum valuation for your debt investors.

    • Chris Sheehan

      Excellent discussion. Just a quick comment on Dharmesh’s point and Nivi’s reply. I agree with Dharmesh — the issue, as an investor, in buying a convertible note is the lack of reward for the level of risk undertaken. The riskiest stage in company building is in the early stages. It’s typical to want at least a 2x step up in share price assuming the value enhancing milestones have been reached — you don’t get this with a convertible note. I hear Nivi’s response of building in a cap on the conversion price, however, the problem is whether the cap will be honered (and the discount) in the next round. The last financing I saw like this resulted in (a) the cap not being honored and (b) the discount changed to warrants over common stock

      • Nivi

        Chris,

        We recently wrote an article on making your debt attractive to investors.

        Regarding honoring existing debt agreements: I don’t see a difference between honoring an existing debt agreement or honoring an existing equity agreement. You can renegotiate either one. The burden is on the entrepreneur to honor his past agreements.

  • JTreiber

    I couldn’t agree more. We just did a convertible debt offering for our seed round and raised about $125k about 6 months ago. It was easy and painless. The investors were mostly friends and family and did not really want to bother negotiating a term sheet for an equity round. In fact, we didn’t spend nearly $10k for our debt deal, since there were boilerplate agreements without any negotiating. Our attorney just sent us the agreements, explained the mechanics to us, and we went around collecting checks and getting the docs signed. We will probably be in the market for a series A this summer and will have a much bigger headache I’m sure. The goal is to do an equity deal and raise angel capital in the neighborhood of $500k that will also allow our seed investors to convert into equity. Any advice on raising an equity round from Angels??? I know many angel groups are out there and often act a lot like venture funds when making investments.

    • Nivi

      A few thoughts:

      1. If you’re raising $500K or less you might want to consider another debt round.

      2. I can’t say this from direct experience but I imagine angel groups are not going to be as aggressive with their terms as a venture fund. Angels are mostly investing as a hobby, not as a job. They’re investing in the founders—if the founders aren’t cutting it, I don’t see angels terminating them and bringing in a new CEO.

      3. Finally, feel free to get in touch with me and Atlas Venture regarding your financing.

  • Jordan Mitchell

    Everything you say is true. Debt is a great way to raise early money into the company. But still actually an unknown approach to many early investors, and if they’re investing they want equity (not to think of themselves as a bank). A couple other tips …

    A legitimate argument for investors against debt rounds is the conflict of interest it produces if they wish to contribute to building the company. Many investors want to help with contacts, deals, etc. — all of which increase the valuation. However, the more they increase the valuation, the less stock they end up with — hence the conflict of interest. This can be addressed with a “maximum conversion valuation” which places a ceiling on the valuation under which the debt converts to preferred stock.

    When investors think of debt, they immediately think of coupling that with a “security interest” in the assets of the company — that’s what banks do, right? Try reminding them that the ultimate disposition of the note is equity and the debt is only temporary. So what good is the security interest? If you’re concerned about giving up a security interest in the assets of the company, consider securing it with founder’s shares instead.

    It’s a bit of a fallacy to say that convertible debt defers a valuation. In my experience, investors have a hard time with the concept of “no valuation”. And in fact, you really should set a term on the note and have it convert to common stock at the end of that term if you haven’t raised a Series A round. Which means you’ll have to pick a pre-mony valuation for common, and yes they will focus on it. They’ll even ask you how many shares they’ll get at that valuation. I have a spreadsheet where I calculate how many shares in the company they’ll get under multiple scenarios, and I just tell them. Selling equity is easier than selling debt, and this helps you focus them on the equity even though it’s a debt structure.

    Warrants vs. discounts. Go with a discount instead of warrants. It’s easier for your average investor to understand, it starts the clock on their equity ownership sooner, and it’s less paperwork over time. Either way, don’t be surprised if they ask for the warrant/discount % to increase over time (like 3-5% per month). If that’s the case, agree to it but set a cap. A cap of 50% basically allows for a doubling the value of their shares (and your company). This isn’t unreasonable — ideas are worth very little actually, it’s the execution that creates the value in the company and if you can’t execute without someone else’s money, then …

    • Nivi

      Great ideas Jordan.

      One additional nuance regarding the conflict of interest: If your investors buy $100K of debt, they get $100K of shares in the Series A, plus more shares for their discount. It’s not as if they are losing value by contributing to the business before the Series A. In fact, they are increasing the net present value of their debt.

      We’ll address this in a future convertible debt hack.

  • oraboy

    Great article and summary of the advantages.

    A few thoughts that come to mind:

    1/ Raising debt seems to be the preferred mechanism when raising seed form friends&family – it’s short, simple and appropriate… but its a tough sell to VCs or Angle-groups (because of the conflict of interests mentions in previous comments and investor’s (implicit or explicit) waiver of control, which is the biggest perk for early VC/angel investors. Any comments/experience/thoughts on ways to go down this route with professional investors would be useful.

    2/ A deeper analysis of the benefits (or potential drawbacks) of a debts seed round in simplifying the closure of a later round would be a useful writeup…

    3/ Additional info. on what sort of provisions (if any) are common or needed for a debt seed in case the company fails to raise it’s first round and runs out of money… what happens then?

  • Nivi

    Someone asked me why investors don’t like cashflow businesses. Some thoughts:

    1. The VCs get taxed on the dividend and then their limited partners get taxed too.

    2. IRR is reduced since the money comes back over time.

    3. VC funds are shut down after 10 years or so—I’m not sure they know what to do with the ongoing cashflow.

    4. They don’t want to sit on the board forever.

    Thoughts and corrections are welcome…

  • Nivi

    dhouston asked a question on Y Combinator News:

    “great article and discussion. lots of yc companies have gone this way — we will probably as well. anyone have experience raising hundreds of k (in convertible debt) from multiple investors, or is it preferred to get that amount from only one or two?”

    My response:

    There are pros and cons of each approach but in general I don’t think the distinction is important.

    Take whichever route is faster — and you’ll only be able to determine that once you’re on the road. I think the pros and cons of either approach are probably a wash.

    On one hand, it is more work to close and manage more investors who are each putting in small amounts. But it is also tougher for multiple investors to send a single coherent signal that influences your next round of financing negatively.

    On the other hand, it is harder to get big checks from a few investors. But once they are sold, getting a bigger check may be better because they will be more likely to help since they are more invested.

    • Abe Sultan

      Nivi,

      In response to dhouston’s question, I agree with you, obviously there are pros and cons for going each route but there are ways to make each work and make the best of each scenario.

      If you raise money from several angels, it will tend to be easier since you don’t need a big check from any of them, the problem can be seen later on a subsequent round if you don’t take the necessary precautions. The problem of raising money from many different people is that you may need to track them down later on when documents need to be signed for a later round and as you can imagine this can become a HUGE headache. You can get around having to track down people for signatures if you require power of attorney when their investment is made. The problem with that is that some investors might hesitate on it and push back so you might need to come up with some creative thinking on how to get them to agree or simply make a small compromise and figure it out later.

      If you raise money from a single angel, everything is easier from the negotiation side of it since you are only dealing with one person and it’s usually not that hard to track since they are most likely somewhat committed to your venture. The problem in this case is that it’s not that easy to raise all the money from one person and it can raise some flags in the event that they don’t want to participate in a later round for whatever reason.

      In my opinion you should set a minimum say $25,000 if you are trying to raise $500,000 and try not to accept any investments for anything less than that (the minimum could change depending on the amount being raised but you get the idea). This will save you a lot of time in the future and allow you to concentrate in your business instead of dealing with inexperienced investors that want to know when their $100 will make $1,000,000.

      Hope this helps
      Abe

  • jake

    Great site!

    For our delaware LLC, I may have US and non-US angels (who may not want to put money in a US entity).

    Is it too complex to put together 2 separate convertible notes, one in the US and one for the local country?

    • Yokum Taku

      Having investments at a parent company level and also at a local foreign subsidiary end up being extremely complicated.

      First, using an LLC as a parent company cuts off almost all traditional venture capital funding due to the flow through nature of the entity and unrelated business taxable income issues.

      Second, investors investing in a local subsidiary will want some sort of exit. Therefore, the interest in the local subsidiary will need to be eventually converted in the parent entity, or the local subsidiary will need to have an independent exit or otherwise be an attractive investment on a stand alone basis. That being said, while I have seen structures that allow investments in a sub to be converted into parent interests (Canadian exchangeable share structures as a result of US parent companies buying Canadian companies in tax-deferred deals are very common), trying to create a custom document for an LLC seems unnecessarily complicated (means expensive legal fees to do it correctly).

      Typical disclaimers apply to this comment.

  • Andrew

    Enjoy your site very much.

    Many people favor a convert for a quick inexpensive seed that delays the valuation question, but I have done that in the past and I would be very reluctant to go this route again for a variety of reasons:

    1) No one knows what they own. If it ends up being longer than anyone expects until you close your Series A, the employees are gonna get mighty itchy. At least with a set valuation you can use options to motivate folks.

    2) Draw a line in the sand for goodness sakes! Who is being wimpy – the investors (cmon – it is a tiny investment, just suck it up and recognize that you want management motivated) or the entrepreneur (don’t be chicken – put it out there – value your idea because no one else will if you don’t). Face it: The fact is investors in a Seed round are gambling and everyone knows it. This is not debt, this is equity. Reasonable people can disagree about the value of anything, you might as well establish early on who is unrealistic – better to find out now if someone is a stingy freak.

    3) There are plenty of terms in the convert that establish valuation if certain financings don’t happen and what ifs are in there anyway, plus interest accruing – saying it doesn’t introduce complexity is not entirely correct.

    4) You may actually find that employees and their friends will invest in your Seed – these people may not have invested in private companies before. If you price it (fairly or generously even), these people will learn about the challenges of equity valuation by being on both sides of the table and will be still more JUICED to see the equity zoom. The notion that every round is intrinsically adversarial is not required – why not give insiders a chance to buy or sell in every round?!

  • Rob

    Great posting.

    Here’s my personal experience using convertible notes/bridge loans to raise money. I’ve done it twice for over $1 million: I enjoyed your posting — here’s my personal experience raising over $1 Million through convertible notes/bridge loans:

    http://www.purchase.com/blog/fundraising/how-to-raise-money-using-a-bridge-loan-or-convertible-note

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