Nivi · May 1st, 2007
Summary: If you raise convertible debt for a seed round, you should negotiate simple and short documents, close quickly and cheaply, and maintain your options for the Series A. But first, determine if you should raise debt or equity—debt is better for small financings with small discounts.
Startups often raise their seed round by selling convertible debt instead of equity because debt is simpler and cheaper. Read Yokum Taku’s excellent series on convertible debt for a primer.
Seed stage convertible debt agreements are fairly simple, especially if your investors are angels. There isn’t a lot to hack in these agreements. You should be more careful if your debt investors are VCs, but these debt financings are still much easier to negotiate than an equity financing.
Later stage convertible debt can get complicated and adversarial. We know companies that took convertible debt from a corporate investor and couldn’t pay the debt back on time—which triggered the corporate investor’s right to take over the company. Fun stuff.
If you are raising convertible debt, you should focus on negotiating simple and short documents, closing quickly and cheaply, and maintaining your options for the Series A. But first…
Determine whether you should sell debt or equity.
Let’s say your seed investors purchase debt with a 20% discount off the Series A share price. If you eventually sell shares in the Series A for $1 each, the seed investors will convert their debt to equity for $0.80/share.
Now, let’s say your seed investors are willing to buy equity for $0.90/share instead of buying debt. Should you sell debt or equity?
You should sell debt only if you can use the money to increase today’s share price by over 25% before the Series A financing. Otherwise, sell equity.
In this example, debt is worthwhile if you think you can sell Series A shares for over $0.90/share × 125% = $1.125/share.
Let’s say you decide to sell debt in your seed round and you raise a Series A at $2/share. After applying a 20% discount, your debt investors pay $1.60/share for their Series A shares. You were wise to sell debt to your seed investors in the seed round instead of selling them equity for $0.90/share.
But if you raise a Series A at $1/share, your debt investors pay $0.80/share for their Series A shares. You should have taken their offer to buy equity at $0.90/share in the seed round.
In general, you should sell debt only if you think it will increase your share price over
today’s market price for your shares ÷ (1 – discount).
Selling debt is usually better than selling equity in a typical seed round.
If you are raising a typical seed round, say $50K-$500K, you probably want to sell debt instead of equity. If you raise enough seed debt to last 6-12 months, you should have enough time to increase your valuation by the 25%-100% required to overcome typical discounts of 20%-50%.
For example, if you raise $250K in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $1.42M. You should raise debt instead if you expect your Series A pre-money valuation to be at least
$1.42M ÷ (1 – .2) = $1.77M (in the case of a 20% discount)
or
$1.42M ÷ (1 – .5) = $2.83M (in the case of a 50% discount).
In general, if you don’t think you can increase your share price and valuation by 2 to 3 times in every round of financing from Series A to Series C, you should probably pack up and go home. In fact, the company’s share price typically increases the most from the seed round to the Series A as the business goes from nothingness to product, users, or revenue.
Selling lots of debt may be worse than selling equity.
If you are raising a large seed round, say $1M, you may want to sell equity instead of debt.
For example, if you raise $1M in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $5.67M. But if you raise $1M in return for debt at a 25% discount, your Series A pre-money will have to be at least
$5.67M ÷ (1 – .25) = $7.56M
for the debt to be worthwhile. $1M of seed financing may not take your Series A valuation above $7.56M—you may want to sell equity instead of debt in the seed round.
How have you decided to raise debt or equity?
Submit your thoughts and questions on raising convertible debt in the comments. We’ll discuss the most interesting ones in a future article.
Topics Convertible Debt
Great post with very helpful examples. My understanding of the real challenge around convertible debt on a seed round is that the A round equity investors (assuming the convertible debt investors don’t lead the round) will frequently press hard to remove the discount on that equity for the seed round investors. So, this presents a problem for the entrepreneur if the A round isn’t oversubscribed, right? What then? (note for entrepreneurs that think they’ll be able to tell the seed round investors and A round investors to work this out amongst themselves: “Ha!”). One tactic is to be clear with the convertible debt that you’d hope they’d ultimately lead the A, which would argue for doing something like CRV’s quickstart program, but what about angels who aren’t likely to drive the bus on the equity round? And how simple is it to attract other investors to follow an A lead that’s buying at a discount? Cheers.
Dick,
The Series A might not want to give the angels a huge discount, but at the end of the day, they’re largely indifferent since the extra dilution just hits the founders.
Really, the situation you’re pointing out occurs in one of two cases:
Worst case though, the founders can just eat the full dilution.
Dick,
Yokum addressed some of the subtleties of who eats the debt dilution in a great comment.
As a matter of practice however, debt is used when the risk is lowered and there’s likely to be a funding event coming up soon. Having raised this sort of financing, I can appreciate angels’ perspective on this matter. Angels are basically working against their interest by funding w/debt when the company has yet to prove itself.
As of late, I’ve heard lots of entrepreneurs talk up debt as the method of financing of choice. What they need to understand however, is that when angels take risks they should be rewarded in the appreciation of value created here since they in essence helped to create it, and the difference between a seed round and the Series A will likely be greater than the 20% they’re likely to receive as a discount to the Series A in a debt scenario. Debt is nice if you believe you’ll be getting funded in a couple of months, but if it’s a plan to avoid a seed financing for 6+ months, then good luck finding takers.
Angel Investment Journal - Angel Investing and Entrepreneur Blog » Debt or Equity // May 1, 2007 at 12:33 pm
[…] has a good post discussing ideas to consider when you are determining whether you should raise debt or equity for your […]
One other thing to note: Convertible notes can shake out differently than equity in the Series A, depending on how the definitives are written (is it taken out of premoney/postmoney, how the cap tables are formed, etc)
In our case, taking conv notes gained us founders an extra 2% or so over what a preferred round would have been, after the definitives/cap table shook out.
Anonymous,
Yokum addressed some of the subtleties of who eats the debt dilution in a great comment.
Should a startup company raise its seed round using a convertible note or Series A Preferred Stock? | Startup Company Lawyer // May 3, 2007 at 1:45 am
[…] 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 […]
I like this structure for the reason that it preserves upside for the angels that are taking the first layer of risk. I have seen a fair number of deals where price-insensitive angels put some $ into a company on a fairly high valuation.
Later, in the first institutional round, the VC takes a clinical look at the business and puts a different (lower) valuation on it. In that case, no one is happy…the entrepreneur feels he has done a lot of work and is moving backwards, the angel feels like he has taken risk and gotten stuffed, and the VC feels (to the extent that they feel) like they are dealing with unsophisticated operators.
This is a neat structure to avoid this problem.
How is convertible debt treated on the Cap Table?
See this article on cap tables: http://venturehacks-dev.mystagingwebsite.com/articles/cap-table
Hello,
I’m a filmmaker, not a financial professional. I’ve put together a business plan and cash flow projections for a project involving a film that we have in production. To raise the money, I’ve been advised to offer 15% simple interest, with an ROI in two years. (The amount we want to raise is $1 million. We’ll complete the project budget with sponsorships.)
I am considering offering equity investment for seed money, valuing the company at $6 million, and selling 2940 shares at a discount of $300 per two shares.
Reading your articles, this structure seems glaringly naive. Will that put off investors? What financial scenario might attract investors to this investment?
Thanks!
It’s also important to note that it’s much cheaper from a legal fees standpoint to raise debt. Legal fees for small equity rounds (from what I understand) cost about $20k, which may be a significant bite into the amount you are raising.