Raising Money for Seed Investment — Using Convertible Debt

Posted on June 12, 2012

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So now that you have your investors, whether angel or friends and family or some other investor, how do you structure your investment; how do you value the investment; what percentage ownership does the investor get and what should the entrepreneur retain? In the seed and start-up stage, these are difficult questions. Each investment is different, and no one answer fits. Sometimes investments are valued on what is put in — I will put in $50,000, you will put in a similar amount of sweat equity, and then we will split the company 50-50.

Other times a venture is valued on what it will be like in the future. Tech companies are often valued on the amount of money they may make in the future, and then that future money is discounted to present value, and the value is then adjusted based on the possibility that the revenues and corresponding net income do not materialize. This valuation method is often referred to as a pro forma valuation method. Obviously, a pro forma valuation is difficult in a start-up because forecasting revenue and net income in the future is extremely difficult.

Convertible debt is often a good solution to solve tricky valuations issues that are common in start-ups. Convertible debt when used in this context is a debt instrument which upon certain events converts to equity in either a specified amount or according to a specified formula. One formula commonly used for start-ups is to convert the debt to equity based on the price of the next round, but giving the investor a premium, such as twenty percent. For example, if a company sells shares in a Series A for $100 a share, the investor can use the balance of the principal and interest owed to buy shares at $80 a share (a twenty percent premium).1 This premium compensates the additional risk that is undertaken at the seed round. More importantly, the valuation issue is deferred to a later round when a more sophisticated discussion can occur with fewer variables.

Issues that need to be decided when doing a convertible note include:
1) What triggers a conversion? Is it another round, and if so, how do you define another round? I have often used the term “qualified financing” which refers to additional investment money in excess of a certain amount.
2) Is the conversion mandatory or optional? I have seen where the conversion to equity is at the option of the noteholder, at the option of the company, or mandatory upon certain events. Obviously having it as an option is beneficial to whoever has the option.
3) Is any premium or additional consideration given for future rounds? This feature is usually necessary to compensate for the risk that a start-up has.
4) What happens if another round does not happen? You do a debt instrument to provide protection in the event that the company does not meet expectations (not uncommon in the start-up arena). How much security (tangible assets, intangible assets, personal guaranties, etc.) does the investment call for?

I have seen these questions answered in a myriad of different ways, and usually it is simply a matter of negotiation. The market is too diverse to say that any one way is standard.

Another big advantage of convertible debt is that it gives protection to investors similar to a preferred instrument without having to do a preferred structure.2 Preferred shares (or units) are often used in investment so that the company does not liquidate the next day and distribute the proceeds pro rata to the detriment of the investor. The convertible note has this protection (you have to pay debt before equity). Additionally, if the company fails, the investor is going to have the ability to collect the most in a liquidation scenario, which gives the investor downside protection — a common feature of preferred instruments.

Finally, the documentation is relatively light. A convertible note typically is a standard note with a few additional terms tacked on in reference. You can get into complexity if you negotiate the operating agreement or investor agreement, but since this will change at a later date, you typically do not. Generally, you have a five or so page convertible note versus a thirty plus page operating agreement or investor agreement. Lawyers charge by the pound, and accordingly, fees should be drastically lighter in the convertible note.

Mike Goodrich
Goodrich Law Firm, LLC

1 If a company may sell quickly and lucratively at the seed round (think Instagram — a rare but occasional occurrence in Silicon Valley), investors will sometimes put a warrant feature in place in order to get additional protection in the case of an extremely positive sales event.

2 An entrepreneur and an investor get together. Investor says, “I will put up the money for fifty percent of the company but I want my investment repaid first.” This extremely common business sentiment is perfectly logical and the basis of preferred instruments. For some reason, corporation and LLC law cannot handle it easily. In corporations, you have to create a new class of shares which requires additional documentation. While not truly outside the box, a preferred class of shares does entail a sophisticate document. In LLC land, the document is inordinately complex and the documents are still being worked through by professionals. All of this equals fees. Generally for any deal under a million, I shy away from preferred capitalization structures.

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