Overview of Startup Seed Financing for Startup Founders

This article is written to provide an overview of seed round of financing for early-stage startup companies. We’ll describe the most frequently used types of seed financing instruments, including convertible notes, simple agreements for future equity (SAFEs), Series Seed convertible preferred stock, and common stock. Therefore we can help startup founders to understand better on choosing the instrument fits their company’s needs.

How much you want to raise in the seed round?

It is common that startups raising seed capital tend to raise anywhere between $50, 000 and $1 million in one or more rounds of financing. Some seed round may be slightly larger and but most likely it would be below $3 million. A financing of $3 million or more would be more likely considered a Series A financing instead of a seed round.

If a seed round where the company raises $1 million or more, a startup may choose to issue equity securities, such as Series Seed preferred stock, as opposed to non-equity securities, such as convertible notes or SAFEs.

How many investors you want in seed financing?

The number of the investors participating in seed financing round vary widely. Seed investors tend to invest in small amounts individually, such as $10, 000 to $50, 000. A startup may need to accept investments from dozens of seed investors to reach a target of $1 million for the total size of the round.

Since the logistics of coordinating so many investors into a single closing may be too much work for founders, startups tend to structure their seed rounds to have multiple closing over an extended period of time.

What are the available financing instruments?

It is critical for startup founders to understand the financing instruments in order to manage the healthy lifecycle of startups.  Convertible notes, SAFEs, convertible preferred stock (series seed), and common stock are typical seed financial instrument, which we would describe one by one.

Convertible Notes

            Convertible Notes are the most frequently used instrument for raising modest amount of capital at the seed stage. They are debt securities that have the key terms of (1) principal amounts that are due at a maturity date; (2) a fixed rate at which interest accrues on the principal balance; (3) a claim on the company’s assets that is senior to all equity holders and typically in the same priority with all other unsecured non-senior debt.

Many investors consider convertible notes as deferred or unpriced equity in substance. The goal of the investments in convertible notes is to convert them into the same preferred equity security the company issues to its first institutional Venture Capital investor in the company’s Series A round, rather than to receive their principal plus interest at maturity. Startups can also use convertible notes as bridge financing to a later-stage equity round or a sale of the company.

Convertible notes convert into different types of equity when certain events occur:

Next Equity Financing Conversion: A later preferred stock financing is the most common trigger for note conversion. In this scenario the principal and interest of each note converts at the relevant conversion price into shares of the same series of preferred stock than the new equity investor purchases in that later financing round.

Corporate Acquisition Conversion: If the startup is sold while the notes are still outstanding, investors may elect to have their principal and accrued interest repaid, or convert the balance of their notes into shares of common stock at a discounted to the price at which the acquirer has offered to purchase of the company’s common stock in connection with the sale transaction.

Maturity Conversion: If the startup reaches the maturity date without having triggered a next equity financing conversion or a corporate acquisition conversion, convertible notes often give investors the options to convert their notes into shares of common stock at a pre-determined price; or leave the notes outstanding, allowing them to continue accruing interest and potentially convert in a post-maturity next equity financing or corporate acquisition conversion.

When a conversion event occurs, convertible noteholders receive equity based on the principal and interest balance of their promissory notes, but at a price that is lower than the price paid by the new equity investors. The lower price the note holders pay is calculated based on either a discounted rate (such as the note holders convert at a price that is a specified percentage like 25% less than the price the new investors in the equity financing pay for their shares of preferred stock), valuation cap (such as the note holders would request define a ceiling, or a cap, on the pre-money valuation at which the notes may convert into stock in a next equity financing to ensure that the noteholders own at least a certain amount of the company upon conversion. When notes contain a discount and a valuation cap, the price at which the notes convert is the lesser of the price calculated based on the discount and the price implied by the valuation cap.

SAFEs

            The SAFE is an alternative to issuing convertible notes when a company is reluctant to issue debt for fear of reaching the maturity date before concluding a Next Equity Financing. The SAFE has all of the same conversion feature of convertible notes without feature of debt. In particular, a SAFE has no maturity date. Until a conversion event occurs, the SAFE remains outstanding indefinitely. Furthermore, a SAFE has no accruing interest. Investors only receive a right to convert the SAFE into equity at a lower price than the investors in the subsequent financing. Recently, seed investors have been increasingly willing to invest in SAFEs instead of convertible notes, particularly true for popular startups.

Convertible Preferred Stock

            Preferred stock issued in a seed round is often designated Series Seed preferred stock. Series Seed preferred stock includes most of the same rights, preferences, and privileges that are usually included in Series A financings. Sometimes, to simplify the documents for seed investors than sophisticated institutional VC investors, Series Seed rounds frequently do not include some of the more mechanically cumbersome provisions that are fairly standard in a Series A financing.  For example, Series Seed financing documents often do not include some or all of the following terms, registration rights to force the startup to file a registration statement to register the note holders’ securities so that the investors can sell them in public market without restriction, right of first refusal and co-sale, anti-dilution provision, drag-along rights, investor designees right on the board of directors.

Common Stock

            Investors who purchase shares of common stock typically receive the same security that the startup’s founder hold. Common stockholder generally have the right to vote for the startup’s board of directors and on other stockholder matters, receive dividends, and receive their proportional share of the company’s remaining assets if the company is liquidated. However, stockholders normally do not have the additional rights, preferences, or privilege the company’s preferred stockholders receive.

Then, Pros and Cons of those financing instruments?

            Convertible Notes

Convertible notes have been a financing instrument of choice for seed rounds for a while. Therefore, most seed investors are familiar with the terms of this instrument and comfortable using them.

It is also much easier to explain to unsophisticated investor about the convertible notes: noteholders eventually receive the same security that a professional VC investor negotiate in the next financing round, but at a discounted price as a reward for investing early through the note. Convertible note documents can be relatively short and simple. There are only a few straightforward terms to negotiate, namely the maturity date, interest rate, conversion discount, and valuation cap. Convertible notes issuances do not typically require amending the company’s governing documents, such as certificate of incorporation or bylaws. The issuance of convertible notes also has a minimal impact on the fair market value of the startup’s common stock, making the company’s equity incentives for employees more attractive and valuable.

However, convertible notes have some notable disadvantages, both from the perspective of startup founders and seed investors. A convertible note converts into a startup’s equity at a price that is not known at the time the note is issued. Therefore, at the closing of a note financing, neither the startup’s founders nor its investors know with any certainty what percentage of the company each may eventually own when the notes convert to equity in the future. Notes that contain a valuation cap provide the noteholders with some certainty around the highest valuation at which their notes may convert. However, founders may have no assurance that the notes will eventually covert at the valuation cap, even though that is typically their expectation. If the convertible note do not convert before maturity, the startup most likely lacks the cash to pay the notes when they become due. Under these circumstance, the investors may demand for higher percentage of the company’s equity in exchange for its extension.

            SAFEs

SAFE documents tend to be even shorter than convertible note documents and have fewer negotiation terms. Therefore, the cost of documenting and closing SAFE would generally comparable less. The greatest advantage of SAFEs to founders is that the instrument neve mature.

SAFEs also have disadvantages. For example, investors may be concerned by the lack of a maturity date, which in some previous cases may have been provided those investors with an opportunity to improve their economics or cut their losses if the startup does not perform well. Furthermore, as convertible notes, founders and investors in companies that have issued SAFEs do not know with certainty the amount of the company they will each own when the SAFEs convert into equity. Compared to convertible notes, strutting a seed investment using SAFEs may adversely affect the fair market value of the company’s common stock for equity incentive purposes. However, the effect is still likely less than it would have been if the company structured the investment using convertible preferred stock and significantly less adverse than using common stock.

            Convertible Preferred Stock

Some sophisticated seed investors prefer investing in convertible preferred stock because, unlike with convertible notes and SAFEs, they have control over the negotiation of the price and terms of the stock at the time of investment. Additionally, preferred stock financing allow founders and investors to know exactly how much of the company they own immediately after the financing closes. Structuring a seed financing using preferred stock can also be advantageous because it may decrease the complexity and cost of subsequent equity financings.

The disadvantages of using preferred stock in a seed financing are mainly from the greater length and complexity of transaction documents when compared to those of convertible notes and SAFEs. These preferred stock purchase agreements are usually less user friendly for unsophisticated seed investors and require more negotiation and knowledge of venture financing terms and convention. Additionally, preferred stock purchase agreements typically have more substantial representations and warranties, often requiring the company to prepare disclosure schedules, which is not a common requirement in convertible notes or SAFEs. Compared to convertible notes or SAFEs, issuing convertible preferred stock typically has an adverse impact on the fair market value of the company’s common stock for equity incentive purposes, despite the impact is still significantly less adverse than it would be if the company structured the investment using common stock.

            Common Stock

            Common stock is by far the simplest of the seed investment instruments. It typically does not include any special rights, preferences, or privileges. Therefore, common stock investment can often be simple and inexpensive. It also creates the incentive between the investors and founders since they are treated the same.

However, the common stock can also be a drawback for investors doing investment on a startup since there are no additional rights, preferences, and privileges that later institutional investors that purchase preferred stock in future financing rounds receive. 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 purpose. Furthermore, the employees would be left with less effective equity incentive. For these reasons, common stock is the least popular investment instrument for startups.

**** The information is only for public education purpose. Should you have any specific questions, please call us at 404.343.7166 or 800.928.4615 ext. 0 to schedule a free initial consultation. You may also schedule a free initial consultation online at http://www.lucylulaw.com/consultation/.

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