The Changing Landscape of Seed Stage Financing, Part II: Introducing the Debt vs. Equity Dilemma

Following up on last week’s post regarding how to select your investors for early seed stage financing, we next turn to the tough and nuanced question of choosing between equity and debt, as you must be asking yourself: Should I sell convertible debt or equity (seed preferred)?  

While there are pros and cons to each, this is a difficult topic to summarize in only a few paragraphs, so the topic warrants a deeper conversation with your legal counsel. For the tip of the iceberg, here are a few pluses and minuses to each choice, starting this week with an analysis of convertible debt. We’ll follow up in the third and final installation of this blog post series next week with the counterpoint to today’s discussion of debt.

What is convertible debt? Convertible debt is technically and typically an unsecured loan made by an investor to the company, evidenced by a “convertible note” where the invested debt converts into equity (preferred stock, typically the Series A) at a price discounted (typically ranging from 25% – 10%) to the price paid (the valuation ascribed) at the first “qualified” preferred stock financing following the issuance of the convertible note. A qualified financing occurs when a certain minimum amount of preferred stock is sold, so the convertible note holder can rest assured it’s a bona fide, arms-length valuation paid by the preferred investor(s). I should add that, in lieu of the discount referenced above, some note investors prefer an equity warrant kicker, a warrant issued to the note holder to purchase a certain number of shares of common (or future preferred) stock.

Advantages:  The company can defer negotiating many of the “hard” points such as valuation, board composition, and a whole host of typical investor rights negotiated in a preferred stock financing. Convertible debt financings are easy to prepare documentation for, easy to explain to investors, comparatively inexpensive in terms of legal fees/cost, and fast to close.

Disadvantages: Interest on the principal accrues. Pressure will mount to close on a certain minimum preferred stock financing during the term of the notes (usually 18 months to 2 years), and if none, the company may have to repay the notes or be in default (although there are ways to address this). Also, as noted in next week’s post as an advantage to an equity round, convertible note investors and the company arguably have misaligned interests; a lower valuation for the Series A round is rationally in the best interest of the convertible note holders because their debt conversion is based on that future preferred round valuation. Of course, the company wants assistance and connections from its early investors, which bumps up against this convertible note investor interest. A price cap can address this last point to some extent.