Anatomy of a Seed Round: Early Stage Equity Fundraising
Being a young professional and new mother, no one knows quite like Sarah that there just aren’t enough hours in the day-let alone time for mindless tasks like doing laundry. “Why isn’t there an app where I can just press a button and someone can come and pick up my laundry and then drop it right back off? I’d pay for that.” And with that a business is born.
Sarah’s story is not uncommon. In fact, many great ventures begin by identifying a solution to a problem. However, an idea is worthless without a willingness to bring it to fruition. Moreover, working nights and weekends will only take our hero so far until they reach the point where they simply cannot go any further without focusing on their business full time. It is also at this point where the founders realize that the necessary development requires large amounts of upfront capital that banks and traditional lenders are just not willing to lend. Unfortunately, it is at this point where many ideas die-and stories end; but they don’t have to.
What is Seed Funding?
In seeking early funding, entrepreneurs ordinarily go to those closest to them; friends and family. In addition to friends and family, an entrepreneur may also pursue wealthy “family friends” and “friends of friends” who are often referred to as “angels.” Carrying with her a hustler’s mentality and a pitch deck, our hero attempts to raise the capital necessary to bring the product to market. It is at this early stage in which a founder must make crucial decisions that will impact the future trajectory of the business and those that will be involved (still think Aunt Sue would be a great investor?). This crucial stage of funding is called the .
In exchange for funding, entrepreneurs may offer investors a stake in the business in the form of debt, equity, or convertible debt or quasi-equity. This post discusses these capital structures and the key mechanics and the associated advantages/disadvantages.
What are Types of Equity Offerings?
The traditional way that most businesses raise money is through obtaining a loan from a lender-debt financing. Unfortunately, this is probably not available for early stage companies due to a lack of credit or assets to collateralize. Some lenders may lend to early stage companies but only if a founder guarantees the loan with some personal collateral, such as their home (yikes!). Even if traditional loans are available at this stage the lack of consistent cash flow to make payments, high interest, and ramifications on default usually make debt financing undesirable.
2) Common Stock
Instead of raising money by taking on debt, Sarah could offer investors an ownership stake in her business. This has the benefit of avoiding monthly installment payments and worrying about the looming repayment obligations. Further, the costs and expenses related to the issuance of common stock is relatively low. For investors, however, the receipt of common stock during the infancy of a venture is often undesirable because those investors tend to favor passive involvement and a liquidation preference (i.e., investors get their money back (and then some) before the Founders get paid). Moreover, by issuing common stock in the initial investment round the value of the common stock will increase substantially more than if a Note, SAFE, or convertible preferred stock were issued, which will have drawbacks when issuing common stock to service providers under a stock plan. Although the holders of common stock may receive a dividend, the issuance of dividends is uncommon for early staged companies because those companies often lack consistent (or any) cash flow.
3) Convertible Instruments
A. Convertible Debt
Convertible debt is a common investment vehicle for an initial capital raise, and the principal document is the convertible note. Like traditional debt financing, convertible notes accrue interest on the principal amount borrowed and require repayment by a certain date (“Maturity”). One key difference, however, is that the holder of the Note is not issuing the Note in order to receive a repayment of principal and interest; instead, the investor wants the principal and interest to convert into equity (e.g., stock) upon certain events (“Conversion”). Ordinarily, the conditions triggering Conversion include: (1) automatic conversion if the Company raises additional capital in an equity round (i.e., priced-equity round of preferred stock) (a “Subsequent Financing”), (2) optional conversion if the Company is sold (“Sale Event”), and (3) optional conversion on or after Maturity.
To further incentivize early investment, convertible notes provide seed investors with additional upside in the form of a discounted price on Conversion. Put simply, when the debt converts into equity the price in which it converts may be subject to a fixed discount (e.g., 20% cheaper than the amount paid in the Subsequent Financing, known as a “Discount”) or subject to a cap or ceiling on the valuation of the triggering event (the “Valuation Cap”). To understand these mechanics let’s take a look at Sarah’s situation.
To fund the development of her business, Sarah approaches her friends, family, and wealthy connections. One such connection is Angela, a local angel investor, who offers to invest $500,000 in the form of a convertible note that matures in 2 years and accumulates interest at 2%. As is often the case, the conversion of Angela’s Note is subject to a Discount (20%) and Valuation Cap ($3,000,000). Sarah and Angela agree that the Note converts upon a Subsequent Financing, Sale Event, or Maturity.
After 18 months, Sarah has grown her business but has burned through most of the initial investment funds. To become profitable Sarah needs to expand her geographical reach and needs additional capital to fund this expansion. Fortunately, Sarah’s hard work has led a VC firm to take notice and has offered $1,000,000 for 25% of her business in the form of preferred stock. If Sarah chooses to accept the VC’s offer, the closing of the financing is a Subsequent Financing that gives Angela the right to convert the balance of the Note ($500,000 (to keep things simple we didn’t apply interest)), into the VC’s preferred stock. However, the price that Angela converts (the “Conversion Price”) is the lesser of the Discount and the Valuation cap as applied to the per share price of the preferred stock.
To calculate the Discount, Angela looks at the valuation offered by the VC ($4,000,000) and divides that by the “fully-diluted capitalization of the company” (basically, the number of shares outstanding or set-aside) prior to the Conversion or closing of the Subsequent Financing (for the purposes of the example let’s say 10,000,000 shares), to find the per share amount ($0.40 per share). We then apply the 20% Discount to get a Conversion Price of $0.32 per share. If the Discount applies then upon Conversion Angela will receive 1,562,500 shares of preferred stock ($500,000 (balance) divided by $0.32 (conversion price)).
To calculate the Valuation Cap, instead of looking at the valuation offered by the VC firm, we look to the Valuation Cap ($3,000,000) and divide that by the number of shares outstanding prior to the Conversion or the Subsequent Financing (10,000,000), to find the per share amount of ($0.30 per share). We then divide the balance of Note (500,000) by the per share Conversion Price of $0.30 per share, resulting in the right to receive 1,666,667 shares of preferred stock.
Because the Valuation Cap results in Angela receiving better terms upon Conversion she will receive 1,666,667 shares of preferred stock upon the closing of the Subsequent Financing. Immediately after the Subsequent Financing and Conversion, Sarah will be the only shareholder holding common stock and Angela and the VC investors will be holding preferred stock that has a liquidation preference on the common stock along with additional rights.
Now imagine instead of receiving an offer for an investment by a VC firm, a large laundry chain approaches Sarah with an offer to buy her business for $5,000,000. In this situation because there is a buyer and business is being acquired in exchange for cash, the Note could convert into common stock. For the purpose of determining the Conversion Price, we ignore the buyer’s valuation (because it is larger than the Valuation Cap) and apply the Valuation Cap to find a Conversion Price of $0.30 per share ($3M cap / 10,000,000 shares). In this situation, the Note will convert into 1,666,667 shares of common stock ($500,000 at $0.30 per share buys 1,666,667 shares), which she will exchange for the pro rata purchase price paid by the buyer of the business. For Angela this is a solid return on her initial investment.
In a situation in which the Note reaches maturity, Angela generally has three options. First, she can demand payment of the principal and interest of the Note and in doing so she would lose her right to convert into equity and associated upside. Moreover, because the Company lacks sufficient cash flow it is unlikely to be able to pay back the Note. Second, Angela could exercise her right to convert the balance of the Note into common stock at the Conversion Price implied by the Valuation Cap. In doing so, however, Angela would lose her liquidation preference-in the event that the Company dissolves the holders of debt get paid back before the holders of equity. Lastly, Angela could offer to extend the Maturity (often, in exchange for better terms), which is what many investors tend to do in this situation. By extending the Maturity, Angela retains her liquidity preference as well as her ability to convert upon a Subsequent Financing or Sale.
B. Convertible “Equity”
A SAFE (Simple Agreement for Future Equity) is an instrument developed by YCombinator and is similar to a convertible note. The key difference is that the SAFE is not “debt” and does not collect interest nor mature. Instead a SAFE focuses on the mechanics that seed investors tend to desire in buying a Note (i.e., the ability to convert upon a Subsequent Financing or Sale). Founders tend to favor the SAFE over the convertible note due to the lack of interest and maturity.
4. Priced Equity (Preferred Stock)
Preferred stock is a class of stock that has a liquidation preference over common stock and is often issued in the larger financing rounds (e.g., a Series A round). If the hallmark of the convertible note and the SAFE is the conversion, then why would Angela not simply ask for preferred stock from the get go? First, any valuation at this early stage is often unreliable. Second, even if a reliable valuation can be made preferred stock often comes with more sophisticated contractual rights and terms and the associated expense of evidencing and negotiating those terms is hard to justify with a relatively small investment. Lastly, later stage investors likely have their own terms, so even if preferred stock were already issued in the Seed Round, it is unlikely those same terms will continue in a later round. Another ancillary concern is that issuing preferred stock in the Seed Round may raise the value of the common stock more than if a Note or SAFE were issued, which is important if the Company wants to issue common stock as a part of an employee stock plan.
Starting a venture and obtaining financing to take that business to the next level is hard-there isn’t a simple way around it. With a bit of diligence and trusted counsel from someone with experience, however, entrepreneurs like Sarah can navigate and understand the various structures and unique terms surrounding the early stage financings. At Rockridge Venture Law, we strive to educate the startup community by providing short and relatable seminars and webinars. In fact, here is a link to a recent presentation on early stage funding to kick off Co. Lab’s Startup Week.
About Shayn Fernandez
Shayn is the corporate lead at Rockridge Venture Law, offering seed-to-sale corporate counsel to entrepreneurs, emerging companies, and investors in all stages of a corporate lifecycle-from formation and fundraising to exits through mergers and acquisitions. Shayn’s practice areas include corporate law, finance and fundraising, securities, mergers and acquisitions, and government contracts. Read more about Shayn, connect with him, and Calendly him.
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Originally published at https://rockridgelaw.com on October 22, 2020.