Raising Your Seed Round with Convertibles
Let’s talk about raising a seed round. Might as well jump into the new year with how to get your startup funded. Elizabeth Yin of 500 Startups did just that in a really clear primer on three seed funding vehicles -- equity, convertible notes and convertible securities -- three ways that entrepreneurs raise seed rounds.
In her January 4 blog post, Yin goes into the basic mechanics of how investors can seed your company. Of the three ways, she says, traditional equity is most widely used, while newer convertible notes gained popularity since 2000, and, and the newest on offer, convertible securities, a hybrid developed and used by 500 Startups and Y Combinator for about a year now. Y Combinator has a very developed and detailed program called ‘SAFE’ which means ‘simple agreement for future equity’ -- pretty much what a convertible security is.
Which is best depends. There a benefits and risks with each. One might fit traditional funding sources better, while another may be less expensive and appeal to more risk-tolerant investors.
Let’s start with traditional equity. You, the founder, swap shares in your company for money investors put in, i.e., equity. It is also known as a ‘priced round’. Seems simple enough, right? Seed Investing has been done this way for years, decades in fact.
Sounds pretty straightforward. Any downsides? Two big ones, in fact. The first is that legal costs may be steep to set up and complete your equity round. Twenty-five years ago, rounds had to be a lot bigger to fund a startup because everything cost so much more – storage, building tools and so forth. Legal costs were based on billable hours, but $20-$50K was not such a big chunk of a 1 – 5 MM raise. Enter cloud storage and Saas tools in the 2000’s – now it is not so expensive to launch a software company. Those billable hours don’t change, though, and make a much larger portion of a $500K raise.
Remember, while good lawyers are expensive, and good securities lawyers charge top dollar, this is no time to go cheap, or worse DIY. The future value of your company, and your exit ownership depends on equity being set up clearly and accurately, even in early stages. In fact, future investors will look for clean, professional cap tables. Do it right now, so you aren’t faced with cleaning up a mess later, most likely at a much greater cost.
Lecture over. What’s the other reason straight forward equity may not be your best way to raise your seed round? In a word, ‘threshold’. Usually an equity round specifies an aggregate sum that you have to raise before you get any money. It could be months from the time your first investor commits to when you actually see the funds. How long can you hold on? Your runway becomes your time limit for raising funds this way, although an enthusiastic and involved lead investor will help you keep things moving along.
What are some other ways to compensate investors? There are of course many, but two popular ones Elizabeth Yin highlights are Convertibles – ‘convertible notes’, and the newer ‘convertible securities’.
Convertible notes have been around for a while. They are fundamentally loans, with interest, which are often paid back in equity instead of cash when they mature. This is because it is in the best interests of a startup’s investors to avoid taking money out of a growing company. Convertible notes are a good way to raise cash quickly in the customarily smaller amounts needed for today’s software start ups, for example up to $500K. Legal fees are likely to be much lower as well.
Yin points out, most Silicon Valley investors won’t call your note on maturity, that is, demand repayment with accrued interest. If you have cash to pay the note, you are probably doing well and so your investors welcome taking equity. On the flip side, if you don’t have the cash and are not doing well, taking repayment would seriously weaken the company, which is detrimental for the investors.
That said, there are complications with convertible notes. They are written with conversion rules which are conditional, in that the price at which it converts for an equity round, depends on the valuation of that round. This means investors can’t know how many shares they will receive until later, which may make them uncomfortable.
Another complication that may deter investors is potential tax liability, because they are technically debt, and the interest is taxable income. If your investors receive equity at the time of maturity, they may still have a tax liability on accrued interest they did not receive in cash. This may not be desirable for some investors. Again, you will need solid accounting advice on whether you need to issue investors 1099’s at the time of payout in equity.
How are convertible securities different?
Convertible securities sound like convertible notes, except they have no interest rate and are not loans. Developed by 500 startups and Y Combinator to address both traditional equity and convertible notes in terms of today’s startup environment, convertible securities are quick access to cash, with low or even no legal fees, and no maturity date. Y Combinator’s product is called ‘Safe’, which means a Simple Agreement for Future Equity, which is just what it is. You the founder get cash for your start up now; your investors get equity later. This method has been in use since early 2016, so it is still very new. Y Combinator says convertible securities “address many of the problems with convertible notes while preserving their flexibility.”
In some ways, it sounds similar to a Kickstarter model. Pay now, and get your product when it’s ready. That said, many investors will not be familiar with this new method for seed funding and may be uneasy about it. Also, the price their shares will be when they get them will not be known at the time of signing, which risk-averse investors find off-putting.
Y Combinator has developed four versions of their SAFE convertible securities that correspond to four types of convertible note. We’ll put a link to their page on this on our Facebook page, facebook.com/ceocoachpodcast. One of the advantages they point out is flexibility. You can close your investors as soon as you have a deal, instead of waiting for all of them to align. And possibly the stars as well.
Here are our top tips for founders about vehicles for investors
1. Make it your business to understand which investor vehicle suits your situation: traditional equity, convertible notes or convertible securities.
2. Similarly, choose your investors wisely to match them with the right vehicle for their risk tolerance, and
3. Don’t go cheap on lawyers and accountants, or worse try to do it yourself. The future of the value of your company -- and all your investment of blood, sweat and tears -- is riding on setting up equity it it correctly now.
Based on a CEO Coach Podcast aired on Cranberry.fm on January 9, 2017.