Debt or Equity in your seed round ?

We spoke recently about the precautions founders need to take when raising "friends and family" money. Another common question is the instrument that the initial financing should be using: debt or equity.

Raising seed capital through debt means that the company will give a promissory note to investors in return for their financing. That debt (also referred to as a "Bridge loan") will be convertible into the first round of financing (the "Series A"), most often at a discount. That discount can be a flat one (from 20% to 40%) or increase over time (2.5% per month the note has been in effect - with a cap). The alternative is to receive warrants for a certain percentage of the amount loaned.

Selling equity means that investors will receive a certain number of shares of the company. These shares will be of a specific class, Preferred shares, as opposed to selling Common shares - used for employees, advisors, etc. They also carry different rights which are negotiated by investors (preference, protective provisions, etc.). See Brad Feld's termsheet series for a great and detailed discussion of these customary terms.

Which is best ? As usual, it depends. On the amount being raised, on the dynamic and timing of the financing, and on the choice of the lead investor(s). Here are a few circumstances that make debt more appropriate in my opinion:

• The seed financing will be put together over a period of time, investors coming in multiple rounds. Whilst it is possible to have several close in an equity round, being able to issue promissory notes at any time is often a welcome flexibility.
• The amount raised is less than $1M, but that threshold is almost deal specific.
• Series A discussions are already under way, and the financing is really a bridge loan - in which case pricing it does not make much sense.

As Josh Kopelman put it in his own post on that very subject Bridge Loans vs. Preferred Equity, angel investors need to think about all possible scenarii, such as the startup is acquired before a Series A is closed (means that you bake in a conversion price) or the equity round takes place months later at a high valuation (so the conversion price is capped). It turns out that I missed Brad's post on the subject: What's The Best Structure For A Pre-VC Investment? that Josh is linking to.

Tags: seedfinancing, angels, angelround, bridgeloan

PS: I am testing Qumana 3.0 Beta to post, and therefore have added the ad below to check out their ad inventory.

Comments

[Bradley Twohig]

What about debt covenants? I would imagine a newly formed company with limited historical cashflow information would have debt covenants that could preclude the company from taking on debt. Anything tied to profitability would make using debt financing difficult.

[Bradley Twohig]

Scratch that I was thinking about traditional debt and not a convertible from a private equity shop. Its monday.

[Bruce Boston]

On the topic of "raising 'friends and family' money"......

Recently, I have been in contact with the SEC talking about a number of issues. In that process, I got to listen in on today's SEC Meeting by the "Advisory Committee on Smaller Public Companies".
I have listed a Podcast of the call here: Podcasting the SEC

I think it's pretty clear that there is both domestic economic pressure and global economic pressure to review the current ways that we are pooling funds at the early stages, here in the USA, and ask if there is a better way to do this.

It's also clear that there is a very open forum through which interested people can express their input on the topic at hand.

-bruce boston
QuidStreet.net

[arieanna]

Thanks for trying Q. :)

[Brian Magierski]

Brad,
Thanks for adding to this discussion. I asked this of Josh as well, but wanted to get your thought as well. In the event of going with the convertible note structure, how does one figure out the conversion price for the event where the startup is acquired before a funding event? It seems this needs to be for a percentage of the deal or company (fully diluted) so as to not cap upside potential. However, wouldn't this just imply a valuation (that may and likely will be different from the valuation that the investors will convert into at the funding event). It seems the differences in those valuations would be tough to reconcile and that an actual price is theoretically being set on the seed round. Thus, the main benefit of the convertible debt path is simplicity and reduced legal cost.