The Best Seed Round Structure Is the One that Closes

Nutshell: People with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone. The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies. In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal. Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care.

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2–3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes. You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money. Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500–750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6–12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12–18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2–3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules. Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10–15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds — where the investors are so friendly that they don’t care about the structure — instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.


Originally published at Silicon Hills Lawyer.

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