If you’ve yet to raise outside capital for your startup, you’re probably still working full-time elsewhere and bootstrapping the startup with your own money.
At this point, you’re probably ready to quit your job and focus on building the startup. You may also want to hire other people, like engineers, to help build a minimum viable product (MVP).
If so, it’s probably time to raise seed capital. But first, you should have a working knowledge of the different types of seed financing instruments. Without it, you’re more susceptible to raising capital in a way that hurts your startup in the long run.
The Basics of the Seed Round
The initial financing round for a startup is known as the seed round. It may also be referred to as the friends and family round if a close relationship already existed between the investors and the founders.
The average seed round funding usually falls between $50,000 and $2 million. Typically, the types of investors are friends, family, and/or angel investors. Venture capital and other institutional investors don’t usually get involved in seed rounds.
Typical Seed Financing Instruments
Before you start asking people for money, it’s worth stopping to consider what type of financing instruments you plan to issue. Investors in a seed round are commonly issued convertible notes, simple agreements for future equity (SAFEs), or stock. Each of these finance instruments has unique features and it’s helpful to have at least a working knowledge of how each one functions.
Convertible notes are debt securities (loans, essentially). But, unlike a bank that issues a loan, investors in a seed round probably aren’t aiming to collect the principal plus interest when the debt comes due. Most investors see convertible notes as deferred equity in the startup, meaning they want to convert their notes into the same preferred equity security the startup eventually issues to VC investors in the Series A round.
So, what causes a note convert? There are a variety of different events that trigger note conversion to equity. The most common event is a Next Equity Financing, which refers to a subsequent preferred stock financing by the startup. This is often the startup’s Series A round. When this occurs, the principal and interest of each note converts into shares of the same series of preferred stock that the new equity investor in the later financing round is issued.
Another triggering event is a sale of the startup. When this occurs, noteholders have the option to (1) have the principal and interest repaid, or (2) convert the balance into shares of common stock, though at a lower price than the purchaser of the startup has offered to buy common stock related to the sale.
A final triggering event is when the startup reaches the maturity date (i.e., when the debt is due) without either of the first two conversion events having occurred. When this happens, investors can usually choose between converting their notes into shares of common stock, or leaving the notes outstanding. Investors are typically reluctant to convert to common stock: by continuing to hold debt of the startup, they preserve their chance to receive preferred stock in a subsequent Next Equity Financing.
Following a conversion event, noteholders receive equity on the balance of their notes. However, the price for noteholders who invested in the seed round is lower than the price for new equity investors, which usually include VCs and other institutional investors in the Series A. The idea here is that the noteholders from the seed round should be rewarded for carrying the additional risk of investing early on.
The price paid by the noteholders from the seed round is determined either by a discount rate or a valuation cap. The discount rate is simply a price that’s lower than the price for new equity investors. A valuation cap is a ceiling on the pre-money valuation—that is, the valuation of the startup prior to investment or financing—at which the notes can convert in a Next Equity Financing. This shields the noteholders from runaway valuations.
For notes that contain a discount rate and a valuation cap, the conversion price is the lesser of the two.
Simple Agreements for Future Equity (SAFE)
An increasingly popular alternative to the convertible note is the simple agreement for future equity (SAFE). The SAFE, which was created by the startup incubator Y Combinator, is essentially the same as a convertible note, but it has neither a maturity date nor accruing interest. Because there is no maturity date, the SAFE remains outstanding until a conversion event occurs (like a Series A round or a sale of the startup). And instead of a right to accruing interest, investors have only a right to convert the SAFE into equity, though typically at a lower price than investors in subsequent rounds.
The SAFE is often used when a company doesn’t want to issue convertible notes because it’s concerned that the debt will mature before it can complete a Next Equity Financing. If this were to happen, the startup would have to seek an extension of the maturity date from the convertible noteholders, which could prompt the noteholders to try to get better terms in exchange for granting an extension. The SAFE protects startups from having to make undesirable concessions to seed investors.
For one recent criticism of the SAFE, you can read this article. For Y Combinator’s recent attempt to address this type of criticism, you can read this article.
In addition to the convertible note and the SAFE, startups may also raise capital by selling equity, either in the form of preferred stock or common stock. This type of equity is more familiar to most than convertible notes or SAFEs. Still, it’s helpful at least to know the difference between preferred and common stock.
Convertible Preferred Stock
Convertible preferred stock is the usual type of preferred stock issued during the seed round. As the name suggests, convertible preferred stock can be converted into common stock. Convertible preferred stock includes mostly identical rights, privileges, and preferences that are usually found in Series A preferred stock. These rights, privileges, and preferences are typically greater than those enjoyed by common stockholders.
Common stock is the most basic form of equity. Shares of common stock typically give the holder the same security held by the founders. The holder generally has the right to vote for the board of directors and on other matters, receive dividends, and receive a proportional share of remaining assets in the event of liquidation. Most investors view these rights as being inadequate, making common stock a disfavored instrument for raising capital.
Issuing common stock also presents problems for startups. Talented employees are often wooed by startups with grants of common stock. Once a startup starts selling common stock to investors, the common stock issued to employees often has a higher valuation. A consequence of this is a higher strike price—the price at which the option can be exercised—for the startup’s options, which makes these options less appealing to potential employees.
Financing instruments can be complicated, and you don’t need to master the subject before you start raising money. Still, for purposes of dealing with outside investors, not to mention your own attorneys, it’s helpful to have a basic understanding of how these instruments work.
If you still have questions about seed financing instruments, you can leave a comment below or contact us directly.