Convertible Debt Posts

Summary: A cap table lists who owns what in a startup. It calculates how the option pool shuffle and seed debt lower the Series A share price. This post includes a fill-in-the-blank spreadsheet you can purchase to create your own cap table.

A capitalization (cap) table lists who owns what in a startup. It lists the company’s shareholders and their shares.

This screencast walks you through our cap table:



The cap table is free

We used to charge for the stuff but now it’s free.


“This is great; we (probably like many other entrepreneurs) tried our hand at hacking up a similar spreadsheet on our own but this is a far more flexible and easy way of visualizing various scenarios. Thanks for putting this together.”

– Drew Houston, Founder of Dropbox

The cap table shows you what you really own

Many entrepreneurs think their pre-money valuation determines their percentage ownership of the company. They forget about the option pool shuffle. They forget about seed debt and its discount. Then they blame their lawyers.

Use this cap table to sketch out how much you will really own after the financing. Find something else to blame on your lawyers.

This cap table is simplified

Our cap table includes the major economic levers of a Series A: common stock, preferred stock, options, and convertible debt. It doesn’t include warrants, vesting, debt interest, liquidation preferences, dividends, the Series B, et cetera.

Cap tables can be a little tricky to understand if you’ve never worked with one before. So we kept it simple.

Your lawyer or accountant will deal with the details that aren’t included in this cap table. They will maintain the company’s official cap table.

Disclaimer — read this

Use this spreadsheet to learn more about cap tables and what your cap table might look like. Then hire a lawyer to maintain the company’s official cap table.

This cap table is provided as-is, with no warranties. It is not legal advice. We make no representations that this cap table is accurate in any way or is fit for any purpose.

We do not take responsibility for anything that results from using this cap table, including, but not limited to, losing all your money and going to jail.

We are not lawyers. Get a lawyer.

Do you have any suggestions or questions?

Please leave your suggestions and questions in the comments and we’ll improve the cap table.

Summary: Convert your debt into equity if you can’t pay it on time. Determine your lender’s return if you sell the company early. Reserve the right to raise more debt. Finally, reserve the right to amend the debt agreement.

Previous convertible debt hacks have discussed

  1. The benefits of debt in a seed round
  2. The economics of debt vs. equity
  3. Making your debt attractive to investors
  4. Keeping your Series A options open

This article collects 4 convertible debt microhacks you can use to supersize your convertible debt.

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Convert the debt into equity if you can’t pay it on time.

Your Series A financing may not occur before the debt comes due. In that case, the company should have the right to

  1. Pay the debt and interest back, or
  2. Convert the debt to common or preferred stock at a predetermined valuation.

Note that the company makes the decision to convert the debt to equity—not the investors. This term lets the company avoid defaulting on the loan. See this great article by Yokum Taku for more details.

Determine your lender’s return if you sell the company early.

The company may be acquired before the Series A. In that case, the debt holders should have the right to

  1. Get their money and interest back, or
  2. Convert their debt to common stock at a predetermined valuation.

The lender chooses between these two options at the time of sale. This term simulates the liquidation preference of preferred stock. You can use the same valuation that you negotiated in the microhack above.

Reserve the right to raise more debt.

If you are raising $500K in debt, you should reserve the right to use the same documents to conduct subsequent closings up to some cap, say an additional $250K of debt.

Many debt agreements don’t require you to get the current lender’s permission to raise more debt in the future. But it is better if your current debt investors clearly understand this possibility. And it will be cheaper if you can use the same documents to close the additional debt.

Reserve the right to amend the debt agreement.

The company and a majority of the lenders should be able to amend the debt agreement and make the changes binding upon the other lenders. This is much easier than getting agreement from every single debt investor.

Examples of amendments include changing the date that the debt matures or the size of a qualified financing.

This term is especially useful if one of your angels is inexperienced or malicious. Without this term, he may try to negotiate a better deal when you request the amendment.

What are your debt microhacks?

Use the comments to share your experiences and questions regarding debt microhacks. We’ll discuss the most interesting comments in a future article.

Our comments are now threaded! Click the “Reply” link beneath any comment to leave a response. Here’s an example of a threaded comment.

As usual, we’ve received many mind-expanding comments—here are some of the very best. The very lucky winner of a mug for great contributions in the field of venture hacking is indicated with a subtle ball of fire.

Dead simple equity agreements

Yokum Taku, a lawyer at Wilson Sonsini, mentions his experience with simple equity agreements that have some of the advantages of debt financing:

“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.”

A caveat: this is not the same as an equity financing with “standard” or “vanilla” terms. Yokum is talking about preferred stock with no rights other than a liquidation preference. So-called “standard” terms are almost always in the investor’s favor.

The benefits of convertible debt

Eric Deeds, a lawyer at DLA Piper, discusses the benefits of convertible debt:

“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.

“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.”

Raising debt from friends and family

Jonathan Treiber from OnCard Marketing recounts his experience with raising debt from friends and family:

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“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…

“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.”

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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.

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.

“[Our existing investors] had put in a right of first refusal. Since I was a young entrepreneur at the time, I didn’t understand that this basically meant that you couldn’t go to any other VC… We could not get a higher valuation because [our existing investors] wanted to put more money in the company themselves. So any time we would talk to another VC, they would talk him out of it: “This is not a good company, don’t worry about it.” So we were really stuck with [our existing investors] for the next round.”

– A Founder

Summary: Raising convertible debt from venture capitalists can restrict your Series A options and lower your Series A valuation—whether or not your investors have a right of first refusal on the Series A. You can keep your options open by raising debt from angels exclusively or raising debt from more than one VC.

Raising convertible debt from angels usually leaves your Series A options open. Why? Angels send a positive signal if they want to re-invest in the Series A, but they don’t send any negative signals to your prospective investors if they decide to pass. There are many simple reasons why an angel may not re-invest in the next round.

You need to be more careful if you raise convertible debt from a venture capital firm. They are more likely to ask for a right of first refusal with respect to some, or all, of the Series A. And, with or without a right of first refusal (ROFR), they can send signals that give them leverage and restrict your options in the Series A financing.

Prospective investors don’t appreciate ROFRs.

Let’s assume your existing debt investors, Blue Shirt Capital, have a right of first refusal on all of the Series A. You’re ready to raise your Series A and Blue Shirt says they want to re-invest. Other prospective Series A investors, such as Herd Mentality Management, will have a standard reaction when they learn that your existing investors have a right of first refusal:

If we make an offer to invest and Blue Shirt exercises their ROFR, then we just wasted our time. If we make an offer to invest and Blue Shirt doesn’t exercise their right of first refusal, then we Offered too much. Yeah… Blue Shirt knows a lot more about the company than we do—they should know what the company is really worth. So, we can only invest in this company if we pay too much. Why should we spend time looking at a company if we won’t have the chance to invest at a reasonable price?

A ROFR can restrict your options and lower your valuation.

At worst, your prospective investors will decide not to waste their time with you, leaving you to take money from your existing investors at a low valuation.

At best, your prospective investors won’t give you an offer unless they are assured that they may co-invest with your existing investors. This forces you to raise money from two investors, implying that you will have to (1) raise more cash than you expected and (2) take 30%-40% dilution from two investors instead of 20%-30% dilution from one investor. Your prospective investors can also coordinate with your existing investors to drive down your valuation:

Hey, Blue Shirt buddy, would you split the deal with us at a $5M pre-money? If that’s what you’re offering, you should go ahead and take the entire round. We won’t exercise our ROFR at that price. We think the company is worth $3M. Sweet! let’s split it at $3M.

(Blue Shirt can use this same signal to drive down your valuation even if they have a right of first refusal on just a portion of the Series A.)

It sucks if your existing VCs don’t want to re-invest.

What if Blue Shirt says they don’t want to re-invest in the Series A at all—whether or not they have a right of first refusal? Herd Mentality will gag on their feed when they learn that your existing investors don’t want to re-invest:

What has Blue Shirt learned since the debt round? Why did they lose interest? They know a lot more about the company than we do—they’ve spent a lot of time with the company. Something is obviously wrong with this company. The only thing worse than this is an episode of Golden Girls. Pass!

At best, once there is no interest left in your Series A financing, Blue Shirt may tell you that they actually do want to invest in the Series A—at the right price. There’s no competition left, so you’re stuck with whatever Blue Shirt offers. However, this is an unlikely outcome since it’s not good for Blue Shirt’s reputation among investors.

More likely, Blue Shirt really doesn’t want to invest in the Series A and this negative signal makes it difficult or impossible for you to raise any more money.

You have the same problems with or without a ROFR.

If you raise convertible debt from a venture firm, you will have the same problems whether or not they have a right of first refusal:

Herd Mentality will still wonder whether they are wasting time since you already have investors on the “inside track”. They will still make an offer only if they are assured that they may co-invest with Blue Shirt. They will still coordinate with Blue Shirt to drive down your valuation. They will still gag if Blue Shirt doesn’t want to re-invest.

Your existing investors can send the same signals with or without a right of first refusal—the signals are simply stronger if they have the right of first refusal. This is a small taste of the game you will have to play when you raise a Series B and your prospective Series B investors interact with your existing Series A investors. Some solutions to this game are coming in a future hack.

For now, you can set up the seed round to avoid playing this game in the Series A.

Try to remove the ROFR.

First, try to remove the right of first refusal by applying the reciprocity norm:

“If you have a right to buy equity in our next round, shouldn’t we have a reciprocal right to sell you equity in the next round? In other words, why should you have a call option to buy the company’s equity if we don’t have a put option to sell you the company’s equity?

Why are we negotiating the next round of financing now? If we’re going to negotiate the next round now, we should negotiate all of the next round, not just your right to invest in it. I don’t want to do the next deal now, I want to do this deal now.”

If you lose this argument, try to contain the right of first refusal to a portion of the Series A. For example, if you raise money from three investors in the Series A, your debt investors would have the right to take up to one third of the Series A.

Overall, accepting a right of first refusal is a minor concession in your debt agreement. Don’t blow up the deal over this term since you will have the same problems whether or not you win this item.

Get multiple investors if you raise debt from VCs.

If you decide to raise debt from venture capitalists, you should try to close two, three, or more venture firms.

As the number of insider investors increases, the influence of any one insider decreases. There is no single source with a single agenda that can send whatever signals it likes. Multiple investors will send multiple conflicting signals that outsiders will not be able to distinguish from noise.

And as the number of insider investors increases, the probability that one of them will send a positive signal increases. For example, at least one of your existing investors may state that they want to invest in your Series A.

You can also make the case to your prospective investors that you raised debt from multiple firms specifically to reduce their individual influence on the Series A:

“Raising debt from multiple VCs is our signal that these insiders are really no different than you. They know nothing more about the business than you do by now. The debt round was simply their opportunity to demonstrate their value to us.”

Finally, you can pit multiple firms against each other to get the best terms for the convertible debt:

Determine what terms Blue Shirt will offer to purchase the entire note. Then tell Herd Mentality that Blue Shirt wants to take the entire note at those terms. Would Herd Mentality consider a more favorable offer? Repeat. Finally, split the debt among all the investors.

What are your experiences with keeping your Series A options open?

Use the comments to share your experiences with keeping your Series A options open. We’ll discuss the most interesting comments in a future article!

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As usual, there were many mind-expanding comments this week—here are some of the very best.

The very lucky winner of this week’s mug for great contributions in the field of venture hacking is indicated with a subtle ball of fire.

Vesting

“Anonymous” discusses his experience with getting vested for time served and how his investors “poked out” two of the company’s co-founders:

“In my first institutional round we successfully got founder vesting put in… with a year’s worth of credit and a monthly vesting rather than an annual cliff. The company was at about 16 months old. At the time, we thought we were losers and just got ripped off but in hindsight that was a genius move. When the lead VC moved to poke out two of our 3 co-founders, that vesting took away some of the sting. Having the [credit] makes them think twice about having to spend the cash to move you out. In the end, we ended up with about 12% of the company fully diluted per founder. That’s pretty damn good, especially when we were at a $650M valuation when we got poked out.

If you are EBITDA negative, you need to expect to see [vesting] in the deal. I would highly encourage you to try and fight for the value you’ve created as much as possible and look down the road at ways in which you can preserve as much of that value as possible. If you are close to break even or EBITDA positive, this should be a non-issue.”

Yokum Taku, a lawyer, mentions that co-founders can negotiate their vesting agreements before they raise financing—this provides extra leverage in the Series A negotiation:

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“Negotiation microhack on vesting:

When the company is newly incorporated and founders shares are being issued (well before the VC Series A financing), consider hard-wiring some of the suggestions (vesting for time served, various acceleration provisions, etc.) into the Founders Restricted Stock Purchase Agreements.

Obviously, all of the provisions of the Founders Restricted Stock Purchase Agreements can (and will be) superceded by the Series A documents, but there’s a possibility that if you lead with something that is not outrageous in terms of vesting and acceleration, it might survive the Series A financing.

One ploy involves a response to the VCs along the lines of “Well – those vesting (and lack of acceleration) provisions are different from what the [fill in number greater than two] founders originally agreed upon. It took us several screaming matches to agree on upon these terms when we issued founders stock and there was a certain level of distrust during these arguments. I don’t know if I have the stomach to go back to [fill in name of potentially unstable founder least savvy about VC terms] to explain why we want to change what we agreed upon. He doesn’t really want to take your money in the first place, and it’ll push him over the edge. He/she’ll think that I’m trying to screw him/her over and may blow up the deal.

Typical legal disclaimers apply to this comment.”

Convertible Debt

“ds” says that high valuation seed financings can cause problems:

“I like [convertible debt] 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.

[Convertible debt] is a neat structure to avoid this problem.”

Yokum Taku, a lawyer, considers whether convertible debt goes in the pre-money or post-money:

“One corollary to the Option Pool Shuffle is “What’s in the fully-diluted shares outstanding if you have convertible notes or warrants outstanding?” The issue is whether shares issuable upon conversion of a convertible bridge note or warrants issued in connection with the bridge should be considered part of the pre-money fully-diluted shares outstanding in calculating price per share of the Series A. Remember, more fully-diluted shares outstanding drives the Series A price per share down, resulting in more dilution to the founders.

Given that many companies are doing convertible note bridge financings as their seed round, this seems to come up relatively often.

VCs will take the position that all of the shares issuable upon the conversion of the bridge note and any warrants granted will be part of the denominator for calculating the price per share of the Series A.

At first glance, it seems like there is a good argument on behalf of the company that the shares issuable upon the bridge note are no different from shares issued in the Series A, and should not be included in the pre-money fully-diluted shares outstanding. In addition, warrants issued in connection with the note typically have an exercise price equal to the Series A price, so these warrants are not dilutive like cheap founders common shares.

The response from the VC is (1) the money from the bridge is gone and the value created by that money is reflected in the pre-money valuation, so the shares issuable upon conversion of the bridge count against fully-diluted shares, (2) in any event, there is a conversion discount on the note conversion so these shares are dilutive to the Series A, and (3) even though the warrants aren’t dilutive today with an exercise price at the Series A price, they will be dilutive in the future in the next round of financing, so the pre-Series A investors should bear that dilution.

Of course, with respect to (1), if there is still money in the bank at the time of Series A, perhaps some portion of the shares issuable upon conversion of the bridge should be taken out of the pre-money fully-diluted share number to the extent of the money left in the bank.

And with respect to (2), perhaps the discount portion of the conversion shares should be included in the pre-money fully-diluted share number, but the rest (to the extent there is money left in the bank) should not.

Finally, with respect to (3), perhaps the warrant overhang is not too different from multiple closings on a Series A round, where the price is set at the first closing, and second closings seem to go on for long periods of time after the first closing at the same price per share as the first closing.

I’d be curious in the VC reaction to this, because the last time I tried this, I lost arguments (1) and (2) (with not too much more logic than “no, those shares are in the denominator” – end of argument) and item (3) warrants was not applicable…

Typical disclaimers about legal advice apply to this comment.

Aside from the swipe about startup company lawyers not negotiating hard against the VCs (which I vehemently disagree with as a WSGR partner), I think you’ve done a great job educating entrepreneurs about subtle nuances in negotiations with VCs.”

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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?

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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.