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Choosing the Right Seed Financing Instrument for Startups by Bettina Eckerle

Choosing the Right Seed Financing Instrument for Startups

When I advise startups or investors about structuring a seed-stage investment, I explain that there are a number of different instruments to choose from.  They vary in complexity and cost and their economic impact on the company, among other things. The most common are:

  • Convertible notes.
  • Simple Agreements for Future Equity (SAFEs).
  • Convertible preferred stock (Series Seed).
  • Common stock.

 This article covers the key pros and cons of each of them.

Convertible Notes

Convertible notes are the most popular instruments for seed investments, and I typically recommend them to clients for a number of reasons. They are easy to understand, and the legal documents tend to be short with relatively few negotiated terms. This translates into low legal fees and a short time to close. In addition, structuring a seed investment as convertible debt typically minimizes the impact on the fair market value of the company’s stock, making equity incentives for employees more attractive.

On the downside, they create uncertainty for founders and investors related to the percentage of the company they each may eventually own once the notes convert into equity. Then there is the term, which is usually 12-24 months, which means they have to be repaid or renegotiated if the Series A does not occur in time. For founders, this creates uncomfortable leverage for investors. Moreover, the terms of convertible notes can sometimes lead to unintended outcomes when compared with the market terms for seed equity. For instance, a plain-vanilla convertible note has features that may effectively give the noteholders more than full ratchet anti-dilution protection or a liquidation preference that is several times the purchase price of the notes.

SAFES

SAFES (which stands for Simple Agreement for Future Equity) have become increasingly popular, and for good reasons. They are basically identical to convertible notes, with the exception that they do not mature and there is no interest. The SAFE legal documents tend to be even shorter than those for notes, and they have even fewer negotiated terms (only the discount and the valuation cap).

On the downside, many seed investors may have never heard of a SAFE. But even educated investors may not like them for the same reasons start-ups love them: the lack of maturity and interest. Also, SAFEs result in the same pricing uncertainty found in convertible notes, and SAFEs can result in the same unintended outcomes discussed in the context of convertible notes. There is also uncertainty about the proper tax treatment. Also, structuring a seed investment using SAFEs may have an adverse effect on the fair market value of the company’s common stock for equity incentive purposes, even if it is less than for preferred stock and significantly less than using common stock.

Convertible Preferred Stock (Series Seed)

Some of the more sophisticated and larger seed investors may prefer investing in convertible preferred stock. It gives them control over the negotiation of the price and terms of the stock at the time of the investment. It also allows founders and investors to know exactly how much of the company they own immediately after the financing closes. Also, convertible preferred stock—when compared to convertible notes and SAFES — tends to simplify a follow-on Series A. Convertible notes and SAFES have several ways to convert in the Series A which are typically not negotiated ahead of time.

On the downside, preferred stock financing documents tend to be much longer and more complicated than convertible note or SAFE documents. With more terms having to be negotiated, it takes much longer to close. In addition, due to the greater length and complexity of the documents, the legal fees are much higher. Also, convertible preferred stock typically has an adverse impact on the fair market value of the company’s common stock for equity incentive purposes. I tend to advise clients to use convertible notes or SAFES for seed rounds, for these exact reasons.

Common Stock

Common stock is by far the simplest of the seed investment instruments. It does not include any special rights, preferences, or privileges. Founders obviously like that the investors receive the exact same security as they own, aligning the incentives between founders and investors, because they are all treated the same. This is of course exactly why investors don’t like them.

Also, structuring a seed investment using common stock typically has the most adverse effect of all the seed investment instruments on the fair market value of the company’s common stock for equity incentive purposes.

I rarely see common stock used in a seed round, and I advise clients to not even try to sell it to potential investors. After all, early stage investors justifiably want to be rewarded for taking great risk. I will write a follow-on piece on the anatomy of a Convertible Note and a SAFE, stay tuned.

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