Convertible debt is King when raising your seed round

You’ve been working days and nights on your new venture for a few months now. You are ready to incorporate your startup and move forward with raising your first round of seed capital from friends, family, business associates or accredited investors. That’s great news. However, how do you value your startup at this stage? Is it really possible to put a pre-money valuation that makes sense for both the founders and the investors? From my experience, valuating a startup at the seed stage does not make ot a lot of sense for most early stage startups. That is why I like the convertible debt instrument at the seed stage. Here are some pros and cons of convertible debt versus equity:

Pros

Some pros:

  1. you don’t have to value your startup NOW. Your startup has barely a functional product and has no history. Would you ask a monkey to throw darts at a dart board to come up with the right valuation? Don’t think so. Customer acquisition brings value but takes time and you usually start getting traction AFTER you have closed your seed round — so it makes sense to skip valuation at the seed stage;
  2. legal docs of a convertible debt financing are less work for your lawyer (more $ in your pockets) and there is no need to have your investors intervene to the shareholders agreement while the debt is still outstanding, so that’s a BIG document you don’t have to negotiate with them;
  3. most convertible debt is unsecured so your investors don’t have a preferred, secured right to your assets in case of default;

Cons

Some cons:

  1. a convertible debt remains a debt. Unless an event has triggered an automatic conversion, you have to reimburse the debt at maturity — you usually don’t have to reimburse an equity investment (redemption rights are however still being frequently requested by VCs at the Series A round);
  2. interest accrue on the principal amount; however, as we will see below, interest rates remain reasonable and are most of the time only payable at the maturity date or are converted together with the principal amount at the Series A round;

Principal Terms

Your convertible debt instrument must provide among other things:

  1. the maximum amount you are looking to raise until the round expiry date;
  2. a round expiry date; I like 6 months so it leaves you time to raise capital on the go (I call that a “blitz” financing) without having to wait on the full syndicate to close the deal — time is money and as a startup everyday you lose not being able to work on your product because of the lack of funds represents higher odds of failure and product delay — so grab the money you can as soon as possible and don’t wait for your next investor to come in;
  3. a maturity date: target 18–24 months to give you time to plan for your Series A (at least 6 month planning);
  4. the applicable interest rate: I would say a middle ground between 6–12% is fair;
  5. automatic and optional conversion mechanisms — that’s really where you can get creative. In any event, if you raise a Series A round, you want your debt to be automatically converted in the same stock subscribed for by your Series A investors;
  6. concept of a special majority: investors cannot take decisions individually, they can only act when a special majority (ex: 66.67% of the outstanding principal) agrees to such action;
  7. consider whether you wish to create a distinction between investors based on the amount they've each put in (ex: less than $100k and $100k or more). “Major” investors can be granted different rights in the shareholders agreement when your Series A round closes;
  8. the discount rate applicable to the pre-money valuation you get at the Series A financing — this will determine the number of shares your seed investors get — 15%-20% is fair;
  9. a cap for the Series A valuation that benefits your seed investors. Let’s say you cap your valuation at $4M for your seed investors, then it means that although your Series A investors value your business at $6M, your seed investors will get the benefit of converting at a $4M pre-money valuation. You want to keep your investors happy so consider it seriously;
  10. most favored nation clause: again, that’s in favor of your seed investors. This clause means that, as you move on with the “blitz” financing and agree to different terms with new investors (that might happen), you agree to give those same, more favorable terms to the investors that have already put money in. It’s being fair with all your investors so it makes sense to add it imho (in my humble opinion);
  11. private issuer restrictions: keep in mind that when raising capital, you need to comply with securities laws applicable in the home jurisdictions of your startup and of the investors. You can’t improvise on this, violating securities laws can result in fines and other bad stuff. Consult with your lawyer on this.

Series A Financing

When your Series A financing finally comes, it’s the right time to sit down with your venture capital investors (who know your industry very well and have the experience to come up with a fair valuation window) and agree on an equity valuation that makes sense for your more mature startup and for your money providers. Your convertible debt investors will then automatically convert at the Series A pre-money valuation with the applicable discount rate. Everyone’s interests get aligned, and your debt is fully converted.

Hey folks, that was really just a short summary of my thoughts on seed rounds and convertible debt (not legal advice). Happy to chat if you need more details.

by Fred Dionne (@fredericdionne)