United States: The Changing Landscape Of Seed Stage Financing, Part III: Revisiting The Debt vs. Equity Dilemma

In the third and final installment of this blog post series, we'll return to last week's question (Should I sell convertible debt or equity?), and consider the other side of the coin: choosing equity instead of debt. We'll need to ask the gating question, though: What type of equity? Common or [seed] preferred stock?

Why not issue common stock for invested dollars? While this is sometimes done (for example, accelerators often take common stock in exchange for a modest investment of $15k – $25k), most investors pushing to have a "priced round" (receiving equity for their investment instead of convertible debt) will want an equity position with senior rights to common stock. At a minimum, they will seek a "liquidation preference" to the common stock, which is at the bottom of the food chain of rights to corporate assets upon a liquidation or sale of the company (i.e., senior debt –> unsecured debt –> preferred –> common).

Additionally, from the startup company's perspective, selling common stock to investors soon after formation at a particular valuation can create unwanted tax concerns for founders who are issued the same common stock upon founding of the company, typically for a per share price of par value of a thousandth of a penny or even less. Tax authorities could later challenge the company's determination of the price at which the company sold or granted such common stock to founders, finding that such price is too low in light of the [much] higher price at which the company sold the same common stock to investors.

Finally, another related tax concern for the startup company: selling common stock to investors establishes a fair market value of the common stock below which the company may not set the exercise price of stock options. The company will likely want to grant such options to consultants, employees and directors going forward. This equity, of course, is the life blood of the young company and options are the primary instrument used for compensation. The aim is to keep the price of these options as low as possible for as long as possible to maximize the upside for the recipient; a high price per share of common stock undercuts this objective.

Why is "seed preferred" stock issued instead of common stock?

First, let's make sure we understand the difference between preferred stock and common stock. Investors who are issued preferred stock have certain rights senior to the "sweat equity" that common stockholders have. These include senior rights to proceeds on a liquidation or a sale of the company; rights to purchase certain amounts of stock issued at subsequent financing rounds to maintain their pro rata ownership of the company ("pro-rata rights"); anti-dilution rights that protect the investors if the company raises more money in the future at a valuation lower than the investor paid; certain protective provisions (i.e., "veto rights" of certain major actions of the company); and possible rights to a board seat, among quite a few others. (See the NVCA form for a good example of a Series A term sheet that shows the variety of potential rights and protections for a preferred stock investor).

Seed preferred (also referred to sometimes as Series AA), differs from traditional Series A, B, and C preferred; it is stripped down and has a limited number of investor preferences and protections. A number of law firms with active practices of representing startups are each pushing their own set of seed preferred stock financing documents, each with the support of various particular active early stage investor(s). As such, there is no clear standard yet. What most seed preferred documents have in common, however, is a simple "1x non-participating" senior liquidation preference to the common; simple protective provisions; weighted average anti-dilution protection (sometimes); pro-rata rights; a guaranteed board seat (also sometimes); and basic information rights. The idea is that the investor will become a shareholder at the time of the investment, knowing how much ownership he or she will have in the company, but to save on complexity, time and legal fees, the investor(s) and the company agree to keep the terms and documentation relatively simple. Additionally, some of the seed preferred forms also have a provision that the seed preferred will obtain the same (presumably superior) investor rights negotiated by the Series A investors at the time of the Series A round. I think this provision can make sense: it helps keep the negotiation of the seed preferred documents to a minimum, although in hindsight post-Series A can make the seed preferred stock feel even more "expensive" from the company's perspective.

Advantages to equity over debt. Certainty. The company knows exactly what it gives up for the investment, and the company and its investors are pulling in the same direction. This creates as much value in the enterprise as quickly as possible. If investors will only accept convertible debt with a price cap, there is an argument just to issue the seed preferred at the same valuation as the price cap. This strategy dispenses with accruing interest and a potential obligation by the startup to pay back the debt if a qualified preferred stock financing does not materialize during the 1 ˝ to 2 years of a typical convertible note term.

Disadvantages to equity over debt. Despite investors' and the company's best intentions, as stock is being issued with a variety of stockholder protections and rights, negotiations can stretch, too, adding to legal fees and time to a closing. Also, the company loses the ability to delay the valuation negotiation; if there was no price cap associated with a potential convertible debt financing, the founders arguably have given up a greater percentage of the company for the same amount of financing had the company been able to close a convertible debt round.

Bottom line. Personally, I typically advise my startup clients (probably not my investor clients) to issue convertible debt. On balance, it's quicker, simpler, and much less to negotiate (and, yes, the legal fees are generally much less). It's easier to continue to do "rolling closes" so a company can take an investment check when the investor is ready without waiting until a "subsequent closing." That said, a price cap (i.e., where the company agrees on a maximum valuation at which the convertible notes will convert into equity) can change the calculus, as it eliminates one of the biggest advantages: it delays setting the valuation for the investment, as it is effectively a "priced round." Back to the above, however: a great investor can trump the bias. If you are offered a "priced round" at a fair valuation from a great investor, my advice is to take the priced equity round.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.