Raising Early Capital For Your Startup

The most vital round of financing for any business occurs early-on and is commonly known as a company's "seed round". Many founders have a great idea for their business, but at the end-of-the-day, when they seek to gain traction for their idea, they are often stalled by the inability to finance their venture. 

This article is designed to give founders and startups a brief overview of what a typical seed round of investment might look like for their company and hopefully equip founders with a basic level of understanding on seed investment rounds. 

TYPES OF INVESTORS

Each investment round has a typical profile of the type of investor in which startups can solicit funds from. In a startup's seed round, there are three typical types of investors: friends and family, angel investors, and super-angels. Each of these types of investors can vary dramatically in their sophistication as an investor. 

Friends and family are obviously the easiest source of capital for startup founders to identify and have access to for early stage financing of their venture. This would include a founder's professional network of sophisticated businessmen who are not angel investors themselves, but who have a high level of sophistication with financing transactions.

Angel investors are high net worth individuals outside a founder's personal network. Oftentimes these investors will invest their own capital into deals. Other times, they will form networks with other angel investors to pool resources together in order to invest in startups. 

Angel investors who invest full-time are sometimes referred to as Super Angels. They will oftentimes form their own funds to invest in startups through. These types of investors are highly sophisticated and invest a relatively small amount of money (compared to VC firms) in a greater number of startups.   

AMOUNT RAISED AND NUMBER OF INVESTORS

In a typical seed round, a startup may raise anywhere from $25,000 (or sometimes less) to $1 million (and sometimes up to $3 million depending on the industry). Any amount raised which is greater than these amounts is typically considered a Series A round of financing. 

The number of investors in a seed round will vary, but it is not uncommon to see several investors at this stage of financing, each investing a small amount of their own capital. For founders, it is important to maintain an updated Cap Table to track these investments. 

TYPES OF SEED INVESTMENT FINANCING INSTRUMENTS

Startups raising seed capital for their venture typically use one or more of the following financing instruments with investors: (1) Convertible Notes, (2) Simple Agreements for Future Equity (SAFE), (3) Convertible Preferred Stock, and (4) Common Stock.  

1. Convertible Notes

In the past, convertible notes have been the most frequently used financing instruments for seed rounds. They are technically a debt instrument (as opposed to equity) which have a principal amount due on a set maturity date, a fixed rate at which interest accrues, and a claim on the company's assets which are superior to the equity holders. However, the most important characteristic of convertible notes is their ability to convert into preferred stock at the company's next big financing event (typically its Series A round). 

This convertible feature gives investors protection on the front-end as a debt instrument and gives the investor the ability to share in the company's growth on the same (or oftentimes better) terms as future financing events with institutional investors. Do to their convertible nature, many investors execute convertible notes with the intention of becoming a stockholder in the company at a future date (as opposed to traditional debt instruments where the lender is only concerned with receiving its principal and interest back, and has no interest in remaining as a stockholder in the corporation). 

Since convertible notes are usually issued to early investors, to compensate these investors for taking on early risk, the notes will oftentimes contain "discount rates" and "valuation caps". 

A discount rate allows convertible notes to convert into the company's preferred stock at a predetermined percentage of the share price issued to future investors in a Series A Round of financing. A common discount rate is 20%, which means convertible note holders will be issued preferred stock (at the company's Series A Round) at a price per share that is 20% less than that of the Series A investors.

In addition to a discount rate, convertible notes oftentimes contain a valuation cap. A valuation cap is a ceiling on the pre-money valuation at which the notes will convert at the next financing event. It essentially locks-in what the investor negotiates the value of the company to be at a future date. By locking into a low (presumably) pre-money valuation at the time of their seed investment, investors will can ensure that they will at least own a certain percentage of the company (or a reasonably accurate estimate) upon conversion of their note into preferred stock. 

Upon the company receiving its next round of investment (presumably a Series A Round), an investor's convertible note will convert into preferred stock at a price per share dictated by the investor's principal amount of the note (i.e., how much they invested in the company) applied against either the discount rate or valuation cap (whichever gives the investor the greatest number of shares). This stock will carry with it the same rights which the Series A investor(s) negotiated with the company. 

Convertible notes are relatively easy to issue and can get startups money quicker than most financing instruments. Because of this, and the discount investors usually obtain with the notes, this is an attractive option for both startups and seed investors. 

2. Simple Agreements for Future Equity (SAFE)

The SAFE is a relatively new financing instrument created by the startup accelerator Y Combinator. It is a favorite tool used by startups and is becoming more accepted among investors. 

Startups love SAFEs because they share characteristics of convertible notes without having to worry about paying back investors at a maturity date if their Series A financing is delayed. The SAFE has the same convertible features of a convertible note, without having the debt provisions (namely maturity date and accruing interest). 

Founders and startups can view SAFEs as a simpler convertible note without the debt features of a traditional convertible note. This is obviously more favorable to startups since they do not have to worry about paying back a convertible note at maturity. However, many sophisticated investors will use this as leverage to negotiate a better deal, pointing out that the increased risk taken on by the investor (i.e., no right to call the note due at maturity and at least recoup some investment) should be offset by a better deal for the investor (perhaps a greater discount rate or lower valuation cap). 

3. Convertible Preferred Stock

Although not as common as convertible notes, startups do issue convertible preferred stock to investors in seed financing rounds. This preferred stock typically has many of the same rights you would expect to see in a later financing round, without some of the more cumbersome provisions (e.g., drag along rights, board seats for investors, registration rights, cosale rights) required by institutional investors. 

Preferred stock is a certain class of stock in a corporation entitling its holders to priority in payment over common stockholders (i.e., dividends and distributions of cash upon liquidation). It also oftentimes contains certain advantageous voting rights. Because of these advantages, preferred stock is almost always demanded by sophisticated investors. 

In the case of a seed investment, the preferred stock issued to investors will most often be convertible. That is, at a certain liquidation event (e.g., IPO, merger, acquisition, etc.), preferred stockholders will have the option to convert their stock into common stock and eventually receive a cash return on their investment. 

4. Common Stock

Common stock is the simplest form of financing instrument because it places investors on the same footing as the company's founders. In general, common stockholders have the right to vote on stockholder matters (including the election of the board of directors), receive dividends (if declared by the board of directors), and receive their proportional share of assets if the company is liquidated. 

The downside of common stock, for investors, is that they are not given preferential rights as a reward for taking on risk as an investor. They are placed on the same ground as the company's founders. 

CHOOSING THE RIGHT FINANCING INSTRUMENT

The following factors are usually considered when determining which seed financing instrument to use for a company's capital raising objectives. 

1. Investor Sophistication

As we talked about above, the level of sophistication of investors in seed financing rounds varies greatly. More sophisticated investors and founders may be comfortable negotiating more complex financing instruments like convertible preferred stock. However, if either the investor or the founder is not prepared to enter into a complex arrangement, or if they do not have a level of comfort with a particular financing instrument, this could drive them to prefer issuing simple common stock or a convertible note. 

2. Investor Preference

Most of the time investors have the leverage in negotiating which type financing arrangement suits their investment. Founders should be aware of this and understand that sophisticated investors will oftentimes only accept convertible preferred stock, whereas friends and family may be okay with a SAFE or common stock. Since founders want to establish a good relationship with their investors early on, it is not common for long and heavy negotiation to occur in a seed round. 

3. Transactional Cost versus Amount of Capital Raised. 

Using a complex financing arrangement will be more expensive for investors and startups. Therefore, the type of financing instrument chosen for a deal is often determined by how much each party is willing to spend in legal fees to get the deal done. A SAFE is the least expensive financing tool, whereas convertible preferred stock negotiations will most likely carry the greatest cost. 

4. Timing

Due to the high number of investors in a typical seed round, multiple closings will likely occur and startups will find it difficult to get all their money at one time. If a startup has a timetable and needs funds quickly, they will oftentimes push for a simpler financing instrument which does not carry as much transactional complexity and negotiation. 

5. Market Cycle

A startup's leverage in negotiating the type of financing instrument in a seed round will be dependent on the current investment landscape. If venture financing is hot, startups will be able to get investors to agree to simpler financing instruments. However, if investment money is tight, startups will oftentimes be required to settle on more complex instruments preferred by sophisticated investors. 

As you can see, a seed round of investment can be relatively easy, but it can also be highly complex. There are several variables at play, and each startup will have unique circumstances driving the particulars of the investment round.

It is our hope that this article helps provide a basic education of what a seed investment round might look like. Stay tuned for future articles taking a more in-depth look at some of the concepts mentioned above. 

If you or your company have any questions or need legal counsel as you take on investors, please feel free to reach out to me HERE.

I counsel founders and startups all over the country on matters pertaining to planning and launching investment rounds for their companies.

For additional articles and legal resources, you can visit my personal website HERE.