By Jason Miller

After forming a company and dividing equity amongst the co-founders, a founding team’s next questions are typically about funding. Often among ambitious founders, venture capital first comes to mind. Today, venture capital is well-suited for growing early-stage companies but rarely available for truly starting companies. In recent years, venture capital has been deployed in larger amounts to fewer companies and there has been a corresponding shift toward larger and more frequent seed or angel investments.

WHAT IS SEED FUNDING?

Seed funding typically refers to the first money invested in the company from a source other than the founders. It can also be helpful to think of seed funding as the money invested in the company before it raises its first round of venture capital.

HOW IS SEED FUNDING DIFFERENT FROM VENTURE CAPITAL?

The main differences between seed funding and venture capital are (i) who invests and (ii) what the investors receive for their investment. Venture capital investments are made by venture capital funds, which are typically partnerships between professional fund managers and institutional investors, like pension funds. Seed investments are typically made by friends and family of the founders, high net-worth individual investors (often called “angels”) or smaller funds focused on seed-stage investments, which are sometimes associated with incubators or accelerators (programs that help new companies get started).

Generally, when venture capital funds invest, they do so by purchasing preferred stock of the company at a negotiated price. Preferred stock is so named for its “liquidation preference,” which entitles the holders of preferred stock to be paid their portion of the residual assets of the company prior to the holders of common stock in the event of a liquidation or sale of the company. Usually the liquidation preference of preferred stock is equal to its original purchase price, but the company and the investor can agree to a larger liquidation preference. Additionally, preferred stock may entitle its holders to special rights with respect to that preferred stock specified in the company’s charter, like “protective provisions” that forbid the company from taking certain actions without the approval of the holders of preferred stock. Preferred stock sold in venture capital financings is almost always convertible into common stock. As a result, and subject to certain negotiated exceptions (i.e. participating preferred), when the company experiences a liquidation event, like being acquired, the holder of preferred stock will receive the greater of (i) the liquidation preference of the preferred stock and (ii) a proportionate amount of the liquidation event proceeds based on the percentage of the company’s common stock owned by the investor after the preferred stock converts into common stock.

An ordinary venture capital investment involves the following documents, among others:

1. Amended and Restated Charter of the Company—this is filed with the secretary of state of the company’s state of incorporation and it creates the class of preferred stock that is to be sold in the venture capital financing.

2. Stock Purchase Agreement—this agreement effects the sale of the company’s preferred stock to the venture capital fund.

3. Investor Rights Agreement—as the name suggests, this agreement grants the venture capital fund certain rights, such as information and registration rights.

4. Right of First Refusal or Co-Sale Agreement—this agreement sets certain limits on the ability of members of the company’s management team to transfer their stock.

5. Voting Agreement—this is an agreement between stockholders to vote their shares a certain way, such as to elect the venture capital fund’s designee as a director of the company and to approve a sale of the company.

When accepting a substantial investment, the time and complexity involved in drafting and negotiating a full set of venture capital financing documents is well worth it. That expense is harder to justify when documenting smaller investments. Accordingly, the primary goal of seed financing instruments is simplicity.  Most seed financing instruments achieve this simplicity by deferring certain complicated decisions until the company raises venture capital. The most common seed funding instruments are: (i) Series Seed Preferred Stock, (ii) convertible promissory notes and (iii) Simple Agreements for Future Equity (abbreviated, “SAFEs”).

SERIES SEED PREFERRED STOCK

The seed funding instrument that most closely mirrors that used in a traditional venture capital financing is Series Seed Preferred Stock. Just like investors in a venture capital financing, investors in a series seed financing purchase, at a negotiated price, preferred stock with a liquidation preference and other negotiated special rights. As a result, and unlike holders of convertible promissory notes or SAFEs, series seed investors become stockholders of the company who benefit from the voting and other rights provided to stockholders under state corporate law.

Series seed financings differ from venture capital financings in that the special negotiated rights attached to the preferred stock sold are usually scaled back and the documentation involved is condensed into fewer agreements. To avoid the expense of drafting and negotiating more technical provisions, like registration rights, that will only come into play later in the company’s lifecycle, series seed investment documents often include a provision that entitles the investor to whatever rights to that effect the company grants to investors in its next equity financing, rather than including such provisions in the series seed investment documents.

The negotiated term a series seed financing does not postpone, however, is arguably the most challenging. As alluded to above, Series Seed Preferred Stock is purchased at a negotiated price. In order to determine the price, the parties must agree on the company’s valuation. Valuing startups is notoriously difficult and choosing the wrong valuation, whether too high or too low, can impact a startup’s negotiating position when raising subsequent rounds of financing. This is one area where SAFEs and convertible promissory notes can be advantageous.

CONVERTIBLE PROMISSORY NOTES

Unlike preferred stock, convertible promissory notes are not issued at a price directly calculated from the company’s valuation and, therefore, investors and the company do not have to agree on the company’s valuation before closing a convertible note financing. In fact, when issuing convertible promissory notes, the company can put off negotiating almost all of the terms typical of a preferred stock financing.

Essentially, a convertible promissory note is an IOU that converts into equity in specified circumstances, such as the company’s next equity financing. In a convertible note financing, as with a typical loan, the company receives cash (or the “principal amount”) from the investor and the investor receives a promise from the company that the company will pay back the principal amount plus interest by a certain date (called the “maturity date”). If and when the company raises venture capital, the convertible promissory note converts by, effectively, using the amount of principal and accrued interest the investor is owed under the convertible promissory note to purchase the investor shares of the preferred stock the company is selling to venture capital funds.  But at what price per share should the convertible promissory note convert?

Investments made earlier in a company’s lifecycle tend to be significantly riskier than investments made later in a company’s life cycle. To compensate convertible note investors for the greater risk involved in making a seed-stage investment, convertible promissory notes typically include one of three conversion mechanisms meant to allow convertible note investors to acquire shares at a lower price than venture capital investors: (1) a discount, (2) a valuation cap or (3) both a discount and a valuation cap.

A discount works just as the name suggests: it is a percentage discount off of the price paid by the venture capital investors. When the principal and accrued interest under the convertible promissory note are divided by the discounted price per share, the convertible promissory note converts into a greater number of shares than it would otherwise. For example, if the company sells a convertible promissory note for $80,000 with a discount of 20%, then sells preferred stock to venture capital investors at $1.00 per share, the convertible note investor will received 100,000 shares ($80,000 / [$1.00 * (100%-20%)]) of preferred stock. However, with a discount alone, the convertible note investor in that scenario will only receive $100,000 ([principal + accrued interest] / [1 - discount]) worth of stock, whether the company is selling preferred stock at $1.00 per share or $10.00 per share. That is to say, if the company’s valuation skyrockets between the time it raises seed funding and when it raises venture capital, a discount alone can leave the convertible note investor with a smaller percentage of the company than he or she might expect. Accordingly, some investors insist on including a valuation cap in their convertible notes.

A valuation cap works by looking to the valuation of the company at the time it raises venture capital. If the venture capital investors are purchasing preferred stock at a price per share that implies a valuation less than the valuation cap specified in a convertible note, that note will convert into preferred stock at the same price per share the venture capital investors are paying. Conversely, if the venture capital investors are purchasing preferred stock at a price per share that implies a valuation greater than the valuation cap specified in a convertible note, that note will convert at the lower price the venture capital investors would hypothetically have paid if the company’s valuation was equal to the valuation cap specified in the convertible note. To illustrate the latter, if the company sells a convertible promissory note that has a valuation cap of $5,000,000, then raises venture capital on a $10,000,000 valuation, the convertible note will essentially provide the convertible note investor a 50% discount relative to the price the venture capital investors are paying. If a convertible note has both a valuation cap and a discount, it will convert using whichever method results in the note converting into the greatest number of shares.

The conversion mechanisms described above are not without their criticism. Most controversial are the similarities between the above and two terms that are frequently omitted from preferred stock financing for being a bit heavy-handed: (i) full ratchet anti-dilution protection and (ii) multiple liquidation preferences. Full ratchet anti-dilution protection is a term triggered in the event the company raises money at a price lower than the original purchase price of the preferred stock, which causes the number of shares of common stock into which the preferred stock is convertible to increase to the number of shares of common stock the holder of preferred stock would have been able to buy had the holder made its investment at that lower price. A multiple liquidation preference is a liquidation preference that is multiple times (1x, 2x, 3x, etc.) the original purchase price of the preferred stock. For example, if preferred stock that was originally purchased for $100,000 has a 2x liquidation preference, the holder of preferred stock would be entitled to receive $200,000 of the proceeds from the liquidation of the company before holders of common stock are entitled to receive any of those proceeds.

To the extent a company sells convertible promissory notes with a certain valuation in mind (as may be indicated by a valuation cap) and subsequently raises money at a lower valuation, convertible promissory notes emulate full ratchet anti-dilution protection in that they convert at the price per share implied by the lower valuation. Likewise, to the extent a convertible promissory note converts into preferred stock at a price lower than that paid by the venture capital investors (whether by application of a discount or a valuation cap) the convertible promissory note emulates a multiple liquidation preference in that it will entitle the note holder to the liquidation preference of the preferred stock into which the convertible promissory note converts, instead of the lower amount the convertible note holder originally invested. To illustrate, if the principal and accrued interest under a convertible promissory note is $80,000 and its discount is 20%, the $100,000 of preferred stock resulting from the note’s conversion will have a liquidation preference 1.25 times the original $80,000 investment.

As mentioned above, some may view the full ratchet anti-dilution protection and multiple liquidation preference features of convertible promissory notes as appropriate means of compensating investors for making risky seed-stage investments. For others, avoiding those features is a compelling reason to pursue a priced series seed preferred stock financing instead. There are, however, some creative solutions that strike a middle ground. To avoid full ratchet anti-dilution protection, a convertible promissory note could contain a minimum valuation or valuation floor to balance out its valuation cap. To avoid multiple liquidation preferences, convertible promissory notes can be set up to convert only principal and accrued interest into preferred stock and to convert the value of the convertible promissory note’s discount or valuation cap into shares of common stock or a “shadow series” of preferred stock identical to that acquired by the venture capital investors, except with respect to its liquidation preference.

No matter which of the equity-like conversion features described above the parties choose, it is important to remember that convertible promissory notes are debt. They appear on the company’s balance sheet as such. They accrue interest. Unless amended, they have to be paid back by their respective maturity dates. These terms naturally accompany debt instruments and there is nothing inherently wrong with accepting them. With that said, debt terms can be a bit incongruous with the spirit of seed-stage investing. One of the reasons convertible promissory notes are convertible is that it is difficult, given the risks of seed-stage investments, to pin down an interest rate that is both low enough to be manageable for the company and high enough to be enticing to investors. In other words, convertible note investors are not in it for the interest; they only really win if the company does well and the convertible promissory note converts into equity. Accordingly, even when convertible promissory notes mature and the debt becomes due, noteholders tend to agree to extend the maturity dates of their notes, because if they do there is a chance the company will succeed and if they do not there is a near certainty the company will fail (and likely be unable to pay back the investor anyway).

SIMPLE AGREEMENTS FOR FUTURE EQUITY

Recognizing that convertible promissory notes are used primarily for their equity-like features, prominent startup accelerator YCombinator developed an alternative seed funding instrument called a Simple Agreement for Future Equity or SAFE. A SAFE is essentially a convertible promissory note with its debt features removed. Like convertible promissory notes, SAFEs convert into equity based on the price of the company’s next equity financing and whether the SAFE has a valuation cap, discount or both. Unlike convertible promissory notes, SAFEs do not bear interest and do not have a maturity date. Without a maturity date, SAFEs can remain outstanding indefinitely without converting into equity. From the company’s perspective, this protects the company from investors using the threat of default to leverage the company’s behavior or extract better terms down the road. From the investor’s perspective, this inhibits the investor’s ability to keep the company accountable as a steward of the investment.

One mutual benefit of SAFEs omitting debt-like terms is that SAFEs have only a few key terms to negotiate. This makes SAFEs the simplest of the popular seed funding instruments, though they are not always as simple as the name suggests. A recent complication is the introduction of the post-money SAFE. In short, a post-money SAFE uses a different valuation cap mechanism than pre-money SAFEs and most convertible promissory notes which results in any dilution from the issuance of other SAFEs or convertible promissory notes before the company raises venture capital being borne by the founders alone and not shared amongst the founders and the other seed investors. According to YCombinator, the advantage of the post-money SAFE is transparency. When a company sells a post-money SAFE for $150,000 to Investor 1 and a post-money SAFE for $350,000 to Investor 2, each with a valuation cap of $10,000,000, the founders know they will go into their venture capital financing having just sold 5% of the company (1.5% to Investor 1 and 3.5% to Investor 2), provided that the venture capital financing is at a valuation greater than $10,000,000. With a pre-money SAFE or a convertible promissory note, Investor 1 and Investor 2 would dilute each other such that they would own less than 1.5% and 3.5%, respectively, and the existing stockholders would own more than 95%. 

WHICH SEED FUNDING INSTRUMENT SHOULD COMPANIES USE?

Given all of the moving pieces described above, it should be unsurprising that choosing the right seed funding instrument depends heavily on the company’s specific situation. A couple of key factors tend to be (i) how much money the company needs to raise, and (ii) from whom the company will raise money. As a general rule, larger financings from discerning investors are more likely to employ Series Seed Preferred Stock, smaller financings from more causal investors are more likely to employ SAFEs and use of convertible promissory notes falls somewhere in the middle. In a way though, asking which seed funding instrument is best is kind of like asking whether it is better to go scuba diving or sky diving—it will be an adventure either way, the important thing is that you do it right.