Seed Investing: Understanding The Landscape - Part I

Starting a company has never been easier. Technology solutions for payroll, accounting, cloud computing and payment systems have made it much cheaper to take care of the back end.

But founders may start seeing more expenses when they hit the fundraising process, some of which come from legal fees. Fortunately for entrepreneurs, several lawyers and investors have tried to cut down these expenses by providing standard documents for seed-stage investing. Unfortunately for entrepreneurs, as more and more new types of instruments and investment documents are introduced, it becomes difficult to distinguish between them or even understand which one is the best option.

In this three-part blog series, we will explain the different types of seed instruments: Convertible Debt, Series Seed and SAFE.

Convertible Debt

Seed-stage investments are often structured as convertible loans. Investors loan money to the company and, in exchange, receive convertible promissory notes. The notes then convert at a specified milestone, usually when the company sells preferred stock in its next financing, into shares of that same series of preferred stock. Occasionally, the notes automatically convert at the maturity date at a pre-determined price.

Discounts and caps

The notes typically convert at a discount (generally between 10% to 20%), so the seed investors would receive their shares of preferred stock at a better price in recognition of the fact that they took an earlier and bigger risk on the company as compared to the new investors in the preferred stock financing.

Over the last few years, as the size of seed and downstream Series A rounds have increased, investors have introduced a cap on convertible notes. For example, if the notes have a cap of $4 million and the company raises a Series A at a pre-money valuation of $8 million (assuming the conversion is based on pre-money valuation), the noteholders will convert the principal amount and the interest at an effective price of $4 million, i.e., 50 cents for each dollar given by the Series A investors.

The company and investors often negotiate whether or not a cap is appropriate, if so what the cap should be and whether the note investors should share the dilution resulting from an new option pool created as part of the Series A round.

From the company's perspective, it is better not to have a valuation cap, because although it offers the investor down-side protection, it has no benefit to the company and can be...