Financing

Generally speaking, founders of a start-up company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A round, the valuation is most likely going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People who are good at using Excel should try to model the different scenarios.
2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A, though this is not always the case.

However, there are two principal reasons to dislike convertible debt from a founders’ perspective:

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A round to be low so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.
2. Investors may request aggressive terms. For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, and drastic measures upon an event of default (i.e., the equivalent of having your arms broken if you don’t repay), among other terms. In a Series A financing, there seems to be some established norms on what is considered typical, while in a convertible note bridge financing, creative investors may suggest some unusual terms.

TLDR: Most startup companies use convertible notes or SAFEs to raise their initial capital.

In most cases, the best way for a company to obtain its first outside capital, or seed investment, is by issuing simple debt or debt-like securities, such as simple agreements for future equity (SAFEs), that require little to no negotiation between the company and the investor.

Convertible promissory notes and SAFEs are the most commonly used securities for raising the Company’s initial capital. There are fairly standard versions of these documents that have gained acceptance among the venture community in the U.S. These forms are generally viewed as providing a fair balance between company-friendly and investor-friendly terms. A leading startup accelerator, Y Combinator, has posted forms of SAFEs on its website which can be downloaded and used by founders. However, because SAFEs are newer, some investors may be less familiar with SAFEs in which case convertible notes may be the best path forward.

Once the company and the investors have agreed on the business terms, such as the investment amount and any key economic terms, a company can frequently use these instruments without having to significantly negotiate the finer legal points, which allows for savings on legal fees and quick closings. Companies should be aware of the need to comply with the terms of the documents, such as obtaining board approval and also make any necessary securities filings, etc.

TLDR: Common stock is typically issued to founders and employees while preferred stock is issued to investors. The preferred stock will reflect the special rights and privileges that investors negotiate for when they invest.

Common stock and preferred stock both represent equity ownership interests of a company. However, preferred stock will typically have special rights exclusive to the preferred stock or a particular series of preferred stock. In general, founders will hold common stock and investors will hold preferred stock. Stock options for employees and consultants of a company will typically be exercisable into common stock.

Preferred stock is usually divided into different series based on different preferred stock financing rounds (e.g., Seed and Series A preferred stock financings, etc.). Common stock is typically a single series (or class) but can be divided into multiple classes with different rights, most often with different voting rights. Other important topics to consider concerning common stock and preferred stock include the following:

• Liquidation Preference: A liquidation preference is the right to receive a specified amount prior and in preference to other holders of a company’s capital stock in the event of a sale or liquidation of a company. The preference amount is usually equal to an investor’s original investment, but other multiples of an investor’s original investment may be used. The liquidation preference can either be paid to the holders of all series of preferred stock on a pro rata basis or priority can be given to particular series of preferred stock. In the latter case, a more recent series of preferred stock may be given priority to an existing series (e.g., the preference for the Series A preferred stock being paid in full prior to the preference for the Seed round). The current trend is for investors to receive the better of their liquidation preference or participation with a company’s common stockholders on an as converted to common stock basis upon a sale or liquidation. This is known as a non-participating liquidation preference since the preferred stock does not participate in the distribution of the company’s assets after payment of the preference. However, preferred stock can also have a participating liquidation preference and receive both its liquidation preference and participation with the common stockholders in the distribution of the company’s remaining assets.
• Protective Provisions (Voting Rights): Preferred stock may have special voting rights that are not afforded to the holders of a company’s common stock, known as protective provisions. These rights can be granted to all holders of preferred stock or unique to a particular series of preferred stock. A protective provision will require a certain percentage of the holders of the company’s preferred stock to approve major actions by the company. Common protective provisions include:
• amending certificate of incorporation or bylaws;
• authorizing a new series of common stock or preferred stock;
• sale or liquidation;
• declaring a dividend payment;
• increasing or decreasing number of directors; or
• entering into related party transactions with officers or directors of a company.
• Director Elections: The holders of preferred stock will often be entitled to elect one or more directors to a company’s board of directors. This allows the company’s investors to be represented on the board, along with the founders and other independent board members not directly affiliated with the founders or investors. The right to elect a board seat may be specific to a series of preferred stock or to all series of preferred stock collectively. If the right is specific to a series of preferred stock, the largest stockholder of the series typically has the ability to appoint the director on behalf of the series.
• Pro Rata Rights: A pro rata right is a right of first refusal in favor of the holders of preferred stock over new issuances of a company’s capital stock. The right is referred to as a “pro rata right” since investors have the ability to purchase a number of the newly issued shares of the company’s capital stock up to their pro rata share of the company’s existing capital stock.
• Conversion into Common Stock: All preferred stock will have a right to convert into shares of common stock, usually on a one-for-one basis. The conversion to common stock is often voluntary, except in the case of a sale or an IPO.
• Anti-Dilution Rights: Most preferred stock will have some form of anti-dilution protection, which is the right to receive more shares of stock in the event that a company sells shares of its stock in the future at a lower price than the preferred stock. The additional shares, or the right to receive additional shares on conversion of the preferred stock to common stock, compensate the holders of preferred stock for the dilutive effect of the lower-priced stock.

In the event of a dilutive issuance, the conversion ratio between preferred stock and common stock will be adjusted such that each share or preferred stock will convert into more than one share of common stock. This allows the liquidation preference for each holder of preferred stock to remain unchanged, as the preference is tied to the number of shares of preferred stock owned, while giving the holder of preferred stock the benefit of more shares on a sale or liquidation of a company with proceeds that exceed the liquidation preference for the preferred stock. There are a variety of ways to determine the change to the conversion ratio, although the most common is known as broad-based weighted-average anti-dilution protection, which takes into account both the number of shares issued and the difference between the original preferred stock price and the newly issued stock price.

• Right of First Refusal and Co-Sale: Significant holders of preferred stock will often have a right of first refusal, second to the company, over shares of common stock held by significant common stockholders, who are often a company’s founders. Additionally, the same holders of preferred stock may also have a right of co-sale, which allows the holders to sell shares of preferred stock, as converted to common stock, in any sale of common stock by a significant common stockholder to a third party, usually on a pro rata basis.

Preferred stock generally has rights that are senior to common stock. Start-up companies typically issue common stock to founders—and options to purchase common stock to employees—and issue preferred stock to investors. One reason for issuing preferred stock to investors is to preserve the ability of a company to issue options to purchase common stock at an exercise price at a significant discount from the preferred stock price. Before accounting and tax rules became more stringent on the valuation of common stock, companies generally used to value their preferred stock as 10 times more valuable than common stock until the 12- to 18-month period before an IPO. In other words, if Series A preferred stock was sold for $1 per share, an option to purchase common stock would have an exercise price of $0.10.

If a company issued common stock to investors, then the exercise price of options to purchase common stock would generally need to be the same price as the price to investors. In this scenario, employees may not believe that they are receiving the benefit of “sweat equity.” However, there are some companies, such as broadcast.com, co-founded by Mark Cuban, which completed all of their pre-IPO financings by selling common stock.

Another reason that investors purchase preferred stock is to receive rights, preferences, and privileges senior to common stock. The most important economic right of preferred stock is the liquidation preference, or the ability to recover the investment and more upon a liquidation or sale of the company. Other important rights of the preferred stock include voting provisions and anti-dilution protection.

TLDR: Confirm they are accredited investors and weigh heavily the decision of receiving investment from friends and family.

You’re at coffee with a close friend. You mention that you’re working on a start-up. After listening to the idea, your friend wants in and offers to invest. How should you react? Remember, to a future investor, a family or friend investment signals more than a dollar amount. It acts as an endorsement, a stamp of approval. Therefore, a friend’s investment offer should not be taken lightly. 

Before answering your friend, you should reflect. Do you have sufficient skin in the game? Have you invested sweat equity in getting your company off the ground? If you haven’t, you’re likely not in a place to be taking an investment from a friend.

Next, evaluate where the company stands in its lifecycle. Does the company need additional investment at its current stage? More investors equate to more opinions, external pressures, and expectations that may not align with the company’s interests. In other words, accepting investments from friends may distract your focus from growing the business.

Fundamentally, it’s essential that your friend understands the risks of start-up investing or, more specifically, that most start-ups fail. If you receive any inclination that your friend is not in a financial position to lose his or her entire investment, it’s best to decline. When considering fundraising from friends, remember the proverb, “Before borrowing from a friend decide which you need most.”

Proceed with Caution

In addition to the practical considerations, entrepreneurs must be cautious not to run afoul of securities laws. The general rule is that a company that offers or sells its securities must register the securities with the SEC or find an exemption. The most common exemption is when a company sells its securities to “accredited investors.”

There are a few categories under which you can qualify as an accredited investor, but the most applicable to family and friends are: (i) individuals whose net worth, or joint net worth with that person’s spouse, exceeds $1 million, excluding the value of the person’s primary residence, and (ii); individuals who had an income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of the two most recent years and has a reasonable expectation of reaching the same income level in the current year. To summarize, before accepting any investment, ask the relevant questions. The time to begin protecting your company starts at the first invested dollar.

The Response

The decision to accept a family member’s or friend’s offer to invest in your company requires close analysis, including practical considerations stemming from the existing relationship and determining whether your family member or friend qualifies as an accredited investor.

Although family and friends rounds are commonplace, they may not be the right path for everyone. However, if you decide to accept an investment from your family or friend to help get to your next goal as you grow your company, remember to clearly communicate risks, expectations, and do your homework. Begin the process at the first invested dollar.

Start-ups based in Silicon Valley typically use either convertible notes or SAFEs to raise initial capital and bridge themselves to their first equity financing round (and sometimes also between rounds). Both of these instruments are relatively simple to negotiate and enable companies to take in money quickly. They also represent a potential right to acquire equity ownership in the company from a corporate perspective but are not equity ownership themselves.

 The alternative to both of these is selling equity—generally selling either common stock or preferred stock.  Equity represents true ownership in the company, rather than a right to acquire ownership. Common stock, though simple to issue, is rarely used for venture investments. Investors usually want special control and financial rights with respect to the company that are easier to implement with preferred stock. In addition, the fair market value of the company’s common stock generally will be driven up by sales of that stock to third parties in an arm’s length transaction. Companies typically want to keep the value of their common stock lower in order to issue options with greater incentive potential to their employees and consultants. By selling a different type of stock to investors (i.e., preferred stock), companies are generally able to maintain a differential between the price that investors pay and the price at which they are able to offer common stock to their employees and consultants. For these reasons, most early-stage Silicon Valley companies scale by financing their operations by issuing equity in the form of preferred stock.

Below is a chart that compares all three securities: