Early stage financing

The best companies in the world are financed by their customers. While this is the ideal state for any venture, external financing may be necessary along the way. Here we offer some advice and learnings on the pros and cons of the different VC financing mechanisms available for startups and early stage companies.

Explaining convertible debt

Seed-stage investments are often structured as convertible loans. Investors loan money to the company. In exchange, the investors receive convertible promissory notes. When the company later sells preferred stock in its next financing, the loan will automatically convert into shares of that same series of preferred stock. The notes would 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.

Using convertible debt for seed-stage investments has the following advantages over selling preferred stock:

A. No Current Valuation. Selling preferred stock requires the company and investors to agree upon the current value of the company, which can be difficult for early-stage companies, especially if investors are not experienced or if founders feel that the company is not mature enough to be fairly valued by investors. With convertible debt, the company and investors generally do not need to agree upon the company’s current valuation. Instead, they defer the valuation decision until the time of the next preferred stock financing. Read about valuation caps on convertible notes.

B. Efficiency/Cost. With fewer and less complicated documents, a convertible debt financing can be completed more quickly, and at a lower cost, than a preferred stock financing. This can be particularly important in a seed round where the amount raised may not be that significant.

C. Status of Investors. Holders of promissory notes are creditors and as such, receive preferential treatment, as compared to equity holders, in the event of a bankruptcy or liquidation. Since early stage investing is very risky, this is an important consideration to some investors.

D. Familiarity. Convertible debt is not likely to present obstacles to completing a future financing because institutional investors, which may participate in the future financing round, are familiar with its structure.

E. No Impact On Common Stock. Selling common stock for fundraising purposes has the effect of fixing the current fair market value of the company’s common stock. As a result, the company will effectively no longer be able to issue equity incentives to potential employees (in the form of options to purchase shares of common stock) at a price below the common stock sold for fundraising purposes without creating negative tax and accounting issues. Issuing convertible debt does not create those same issues for the value of the common stock.

If you are looking for a relatively quick and cost-effective method of raising capital and plan to raise more equity capital in the future, convertible debt may be a good option.

Here is a link to Y-combinator's SAFE - Simple Agreement for Future Equity, probably the easiest and fastest implementation of a convertible debt instrument: