Startup Seed Financing

A comprehensive guide to raising capital in the seed stage: SAFEs, convertible notes, common stock, and preferred stock.

Published June 1, 2022 ET
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Startup financing is really an exercise in:

  • Economic theory and macroeconomics
  • Accounting (financial and management)
  • Corporate management
  • Banking, crediting, debiting
  • Risk management
  • Securities law, employment law, tax law, insurance law
  • Financial planning
  • Hiring, incentivizing, long-term employee retention
  • Supply chains
  • Politics and political engines
  • Venture capital
  • Public relations

Key Takeaways from HBR

Raising money takes a lot more time than one might think. Preparing, negotiating, due diligence - that all takes time. And that time also has an opportunity cost with running the actual business.

Raising money can be expensive. Going public can cost between 15% and 35% of the offering, not to mention the added costs of being a publicly traded company (SEC, legal fees, increased insurance fees). Raising substantial debt also requires stringent audits and independent reviews.

You also have to give up a lot of confidential information and strategy to convince financiers to believe in your vision. That doesn't feel very good and it exposes you. While you cannot eliminate the risk, you can minimize it by discussing the issue with the lead investor, avoiding some sources that are close to competitors, and talking to only reputable sources.

You must assume the deal will never close and keep looking for investors even when one is seriously interested.

Understanding the Playing Field

To understand seed financing, you need to understand:

  • Debt: issuing bonds, issuing convertible debt
  • Equity: selling common stock, selling convertible preferred stock

Each has upsides and downsides, requirements, costs, risks, and constraints.

Standardized Legal Documents for Seed Rounds

Silicon Valley has tried to standardize some of the legal docs:

  • TechStars Model Seed Funding Documents
  • Y Combinator Series AA Equity Financing Documents
  • Founders Institute Plain Preferred Term Sheet
  • Series Seed Financing Documents drafted by Fenwick & West

Selling Common Stock

Common stock is the same security that the startup's founders hold.

Common stockholders generally have the right to:

  1. Vote for the company's board of directors and on other stockholder matters
  2. Receive dividends, if and when declared by the board
  3. Receive their proportional share of the company's remaining assets if the company is liquidated

This is by far the simplest way of raising money, as typically no special rights like with preferred stock. Selling common stock in your seed round is something you only really see if the investor is a wealthy close family member or friend of a founder who does not normally invest in startups.

It is the least preferred way to raise money in a seed round. Common stockholders have more risk than preferred stockholders in the event that company goes under because preferred stockholders have dibs on proceeds from the selling of assets.

Securities Law

"Section 4(a)(2) of the Securities Act exempts from registration transactions by an issuer not involving any public offering."

  • You don't need to register with the SEC unless your company is public
  • More than 35 non-accredited investors is considered public
  • Exception: Rule 506(c) allows broadly soliciting to only ACCREDITED INVESTORS

Selling Convertible Preferred Stock (Series Seed)

Also not a very common way of raising money during the seed round.

Series Seed preferred stock is typically used when you have a sophisticated investor funding the largest amount in the round (often called a lead investor), and they are primarily negotiating the terms of the financing with the company.

Series Seed preferred stock usually has far fewer rights than stock issued in a Series A. Most Series Seed preferred stock does not contain:

  1. Registration rights
  2. Rights of first refusal (pro-rata)
  3. Price-based anti-dilution provisions
  4. Drag-along rights
  5. Investor designees on the board of directors
  6. Co-sale/tag-along rights

Common Rights in Preferred Stock

  1. Pre-emptive Right (a.k.a. Right of First Refusal, Pro Rata Right) - right of existing investors to purchase more shares in a future round
  2. Most Favored Nation (MFN) - requires existing Series Seed stock to be given the same preferences as the next round if those investors receive greater protections
  3. Information Right - basic financial reporting on a periodic basis
  4. Board Right - right to appoint at least one member or non-voting board observer
  5. Voting Right - requirement that the startup obtain majority consent before certain actions

Issuing Convertible Notes

A convertible bond is a fixed-income corporate debt security that yields interest payments but can be converted into a predetermined number of common stock or equity shares.

Key characteristics:

  • Conversion from bond to stock can be done at certain times during the bond's life
  • The conversion ratio determines how many shares you get from converting one bond
  • If stock price decreases since the bond's issue date, the investor can hold the bond until maturity and get paid face value
  • Convertible notes have an annual interest rate (typically 4% to 8%)
  • Most mature between one and two years after issue

Conversion Events

Next Equity Financing: Investors typically require the company's Next Equity Financing raise new proceeds above a certain dollar threshold (often $1 million) to automatically trigger conversion.

Corporate Transaction: If the company is sold while notes are outstanding, investors may elect to either:

  • Receive principal and accrued interest
  • Convert at a discount to the acquisition price

Maturity: If maturity date arrives without a conversion event, noteholders can:

  • Convert to common stock at a predetermined formula
  • Demand repayment
  • Leave the notes outstanding

Discounts and Caps

  • Discounts typically range between 10% to 30% off of the preferred equity price (most common: 20%)
  • Most notes also contain a valuation cap to prevent "valuation whiplash"
  • When notes contain both, they convert at whichever price is lower

SAFEs (Simple Agreement for Future Equity)

A SAFE is an agreement between a company and its investors, particularly in the Seed Stage.

It attempts to be a better version of convertible debt, retaining the positive characteristics while addressing the negatives:

  1. No maturity date - SAFE remains until a trigger event happens
  2. No accrued interest
  3. It's not debt - so it doesn't show as an account payable on the balance sheet

SAFE holders get non-participating Preferred Stock once Next Equity Financing occurs.

The first SAFE was created in 2013 by Y-Combinator.

Pro-Rata Rights

A pro rata right allows investors to maintain their initial level of ownership percentage during later financing rounds.

MFN Rights

Most-favored nation rights allow SAFE investors to get the same terms as future SAFE investors if they get better terms.

409A Valuation

Section 409A excludes stock options from the U.S. definition of "tax-deferred compensation" unless certain rules are followed.

Companies can largely ignore Section 409A if they give employees stock options with a strike price exactly equal to the fair market value (FMV) of the common stock at the time of the grant.

When Do You Need a 409A?

  • As soon as you want to grant options
  • At least once every 12 months
  • When a material event occurs (new financing, acquisition offer, significant changes to financial outlook)

The 409A Process

  1. Determine enterprise value
  2. Allocate across equity classes to arrive at FMV for common stock
  3. Apply a discount to account for the stock not being publicly traded

References