To provide some background, I am currently advising an early stage SaaS company that is looking to do the first round of financing. They do not have revenue and are in the process of setting up the minimum viable product (MVP) as well as bringing onboard critical team members in order to start executing on the vision. For the most part such members have engineering backgrounds. The company is based out of the East Coast in the US.
My question here is really concerning the structure and strategy of their financings as they build the business and plan to scale things up. Regardless of them getting a lead or putting together a syndicate to cover the initial round... What are your thoughts with regards to the advantages as well as disadvantages from doing a Seed round via an equity financing vs. doing the Seed round with convertible notes with standard terms. How would this change upon the next round (Series A)?
Many thanks for the help!
Convertible notes are cleaner and easier in pre -revenue companies since you have little to generate a valuation. You should make sure they do not accept onerous terms or too short of a maturity, and include forced conversions, but it is the most common way to kick the valuation can down the road a ways until you actually know if there is a product and revenue. A Series A will likely be equity, either preferred or common, not notes.
Equity financings are great if you have the time and runway. Probably better to go with an equity round if you are at a Series A and you are ready to bring in institutional investors.
If you are at a Seed stage perhaps the best way is to do a note round and delay the process of putting a price tag on your company and have it done by a real sophisticated investor.
It could be dangerous to bring on VCs at a Seed stage. If they don't reinvest on your Series A round that will send negative signals to the market and will make it harder to raise the next round. You raise money from these folks to speed up the machine and not to build it. For that reason Seed is better with angel investments as it is expected that on Series A's most of your angel investors will not follow on by reinvesting.
On convertible note rounds you want to really focus on the following:
For equity rounds some of the things to look for include:
Overall, notes are cheaper and faster than equity financings. While a note round can be done in less than a month, you would be very lucky if you can close the round via equity in under 3 months. This is mainly given to the negotiation of all the clauses. Unless you have a respected lead investor that is willing to jump in you may want to go with notes.
Some of the mistakes that you will encounter with notes is mainly investors that are not aligned with the future upside of the business. People that are more in it for the interest that they are receiving on the money invested. If you go on default reaching the maturity date of the note without an additional round, that will convert the outstanding debt into equity, you might get into trouble. Last thing you want is to shorten up the runway by taking the small cash that you are bringing from revenues to repay...
If you have great lawyers, in terms of costs for convertible notes, you are looking at $5K to $15K to get the note round done. Equity rounds costs really depend on how sophisticated the lead investor is but are typically over $15K. Sometimes the cost of equity rounds can get out of hands. My piece of advice is that you never leave it to the lawyers. Always control the conversation. I talk more about this on my book which you can find here.
In my experience most companies come up with an idea then decide the next natural step is to get funding.
I would flip that and challenge them to find validation from potential customers. So much of this is contextual, but broadly:
1) start with the hypothesis of what value they'd be adding to customers
2) hypothesize about which types of customers would say "holy smokes I have to have that"
3) find those customers
4) ask good questions and better understand those customers' problems
5) offer a solution and get the customers to pay upfront, before development happens
If it's truly a unique idea then customers will pay. Absent that it's still just an idea without validation.
Again, this is all highly contextual.
As a corporate and securities lawyer, I can tell you that convertible notes are much cheaper to execute. Also, look into SAFEs. The point is to postpone valuation until a later point.
Easier to get convertible notes at this stage - avoids the whole valuation issue. You do not want to sell commons - likely to get crushed by the SA.
Different investors will offer their terms differently depending on their appetite for risk. In Silicon Valley there is a hybrid animal where equity has a "fixed note" quality but in reality is equity. The East Coast has the convertible note preference since debt can be deducted quickly as opposed to equity loses if the deal goes South. Just see what they offer on the term sheet. But most importantly research and determine your own valuation in the beginning by looking at comparables.
1. easier to execute
2. cheaper on the legal side
3. do not require valuation discussions, which are quite meaningless for early stage startups
Y combinator blog has some discussions om SAFE .. The hybrid equity model.
See below for a good article noting the pros and cons of convertible debt rounds. It clearly depends on the needs of the entrepreneur and what their priorities are (timing, strategic partnership, reducing legal fees etc).
I will say I've seen strategics (CVCs) push small convertible rounds when they like what they see but are not interested in leading an equity round. They are much more open to convertible notes than traditional VCs.
Hope this is helpful!
Pardeep, here's a summary of why founders and investors alike would be well advised to avoid using convertible debt.