Seed Round Convertible Debt vs. Preferred Equity

The most common forms of investment in early stage business are convertible debt and preferred equity.  Common stock can also be issued, but in general investors who want equity choose preferred shares because it gives them certain rights that are not shared by the common stock, both in regards to the company and in the case of a follow-on capital raise.

Preferred stock is a new class of stock issued by the company which is given certain rights apart from the company’s common stock.  This can include a dividend right, liquidation preference, conversion rights, pro-rata rights, etc. It is equity and the shareholder has ownership rights in the company (and is owed corresponding fiduciary duties by the board and management).

On the other hand, convertible debt what it sounds like – debt which is convertible into equity at some later point in time.  The angel then receives a discount on the conversion price to reward their risk.  If all goes according to plan, the conversion generally takes place upon receipt of the next round of funding.  The debt can feature many corollaries to the bells and whistles given to preferred shares noted above.  While the intention is for the debt to convert, and many investors think of it as quasi-equity, until it converts it is debt, and needs to be treated as such (with attendant fiduciary duties from the board and management).

The biggest benefit to using the convertible debt model is that it allows for the investment to be made without the company and investor coming to an agreement on a valuation.  As an example, I did a convertible debt deal a month ago where the investor made an investment of $200,000 into a startup with a 20% discount.  The debt will convert upon the startup raising $1m within the next year.  What this means is that upon that startup receiving its next material round of funding, the angel will receive $250,000 ($200k with the 20% discount) worth of shares at the pre money valuation agreed to for that next round, and on equal footing with the new investor (i.e. same class of shares).

In that previous deal, the company believed its valuation to be $5m, but the investor thought it was closer to $3m, and as with all these very early startups, there was no definitive way to break the logjam. Using the convertible debt model, the investor was able to invest, and by the time the next round happens, more information will be available to the company and the investors and that new valuation should be a better reflection of the actual value of the company.

The downside to using convertible debt is that it increases the risk that one party is going to get a sweeter deal than intended.  Continuing with the example above, if the Company receives a valuation of $20m, the investor would have been better off doing a preferred share deal at any valuation below $16m (the effective valuation of the original investment reflecting the 20% discount).  As discussed, a cap can be put in place to shift some of this risk from the investor to the founders, but it cannot be wholly mitigated without agreeing on a current valuation, which negates the point of doing a convertible debt transaction. The cap is also not without a downside, however, as future rounds may view it as a cap on valuation – for that reason it should never be told to a future potential investor before they make an offer. It should be noted that the above-mentioned deal did not contain a cap, and my understanding is that they are not as common as they were circa 2010.

If the parties can agree to a valuation that is a good representation of the value of the company, doing a series seed deal issuing preferred shares makes more sense.  Giving equity gives the angel the full upside for the risks he is taking.  If the valuation is high, however, it also gives the angel the full downside.  For example, if a company is initially valued at the seed stage at $6m, but the next round is done with a $4m pre-money valuation, the equity investor sees an immediate 33% decrease in the value of his investment.  If the valuation is too low, the angel will end up owning a disproportionately large percent of the company compared to the founders, which acts as a disincentive, and limits equity available for bringing on future talent.

Finally, doing a convertible note deal is simpler and cheaper from a legal costs point of view, but the cost difference is not so great that it should be outcome determinative.

Minton Law Group in the News

I was recently quoted by TNW:
11 Major Public Relations Mistakes (and How to Learn From Them) 10.  Know Your Grammar Rules!

“If people are analyzing your word usage, they are not thinking about your message.  Nobody is immune; when Steve Jobs once called an iPod the “funnest” ever, the following buzz was not on the features of the new product, but on the correct usage of “fun” in the English language.”


I had the wonderful experience today of having a client get up in front of a room of twenty-odd people and tell a story about just how happy he was with the respresentation I had given him.  His story included a metaphor in which I and my opposing counsel were two prize fighters and, to put it nicely, I was less than gentle with my opponent.

While having a client sing my praises was fantastic unto itself, I really appreciated that in this case the positive outcome was not the result of finding some obscure point of law, but instead had come from really understanding my client’s position and formulating a negotiating strategy based upon his wants and needs, and then executing that strategy in a way that he saw (rightfully) as a homerun.

Any attorney can read and interpret a statute and add roadblocks to a deal, but the desire to go beyond that to really help my clients as a business advisor who helps them get deals done was a large part of why I started this venture, and to see it play out in such a positive manner for my client was one of my must fulfilling moments, professionally, as I have had to date.

An Agreement in Time Saves Nine

I was recently asked by a reporter what my advice would be to entrepreneurs regarding the dissolution of a partnership.  I stated that the best thing a group of entrepreneurs can do to deal with a partnership breakup or dissolution is to agree to the steps that will be taken and the format of the dissolution long before things get acrimonious or go otherwise go downhill.  A good attorney will include a section detailing such steps in any LLC or partnership agreement at the beginning of the venture.  Agreeing to what will happen upon the breakup of the partnership before things get ugly not only will save the partnership legal fees upon dissolution, but also guarantees that the partners all have clarity on what the results of the dissolution will be, often making the breakup less likely to happen in the first place.

The Young Entrepreneurs Council

The Minton Law Group is very pleased to announce that Peter Minton has been selected to join the Young Entrepreneurs Council.  He is very excited at the possibilities opened by joining this group of inspiring and aspiring entrepreneurs, and looks forward to working with them towards mutual success.

If you want to learn more about the Young Entrepreneurs Council, please click here.

Posted in YEC