In the past several years LaunchCapital has seen a significant increase in the use of convertible notes at the seed stage. The initial rationale for their usage made sense given the seed fundraising . But, as the standardization of seed stage terms has improved markedly in the past several years, the value of a priced round now significantly outweighs the previous advantages of the convertible note.
What were considered major advantages of a convertible note versus a priced round and what has remained relevant today?
#1 — Avoid establishing a valuation
The initial belief with a convertible note was that it would enable a startup to delay the valuation discussion to the Series A. Assigning a valuation to a seed stage company is a difficult and non-formulaic task, so the ability to skip the valuation process AND raise funding is compelling. However, as convertible notes became more commonplace investors increasingly treated the cap on the convertible note as the pre-money valuation — and would negotiate and evaluate the company accordingly.
#2 — Simpler and cheaper
A convertible note is basically short term debt that converts to equity. There is some nuance with the structure but there are only three key elements that vary: Discount, Cap and Interest. So, there is minimal complexity and in turn limited legal cost in the creation and execution of a convertible note. On the other hand, the term sheet of a priced round in addition to the valuation terms, there are voting rights, governance and board of directors. As a result, the price of a term sheet previously could cost a company $10–15k even at the seed stage. Now while the above elements are still part of a term sheet, the explosion of seed stage financings has led to the standardization of a seed stage financing with only discussions and negotiations around a couple items. In total, your typical seed stage financing should now only should cost $5–10k. Part and parcel with that term sheet standardization is the shifting of power dynamics away from investors. The draconian and unnecessarily complex terms of old are largely gone.
So what do we like about Price Rounds?
#1 — Formality of establishing a board, option pool and fewer legal issues
Although the term sheet of a priced round costs slightly more than a convertible note, the added value significantly outweighs the costs. We have found establishing great corporate hygiene as early as possible pays massive dividends later. Establishing corporate responsibilities, a board of directors and voting rights from the very start prevents foundational breakdowns down the road. Every term around corporate structure on a term sheet exists for a reason — to prevent a potential issue that can arise down the road — so establishing those terms earlier prevents them from being a problem later. Good governance is good business. Similarly establishing an option pool sooner than later is invaluable for recruiting talent and letting employees know exactly what they’re gettingin terms of value and vesting begins for founder and employees.
#2 — Creates less problems down the road for Investor and the entrepreneur
As mentioned before, a convertible note is just debt that converts to equity upon the next financing. It does not come with any of the protections or definite rights of being a preferred equity. As a result, Series A investors as part of their financing proposal to a startup, may require convertible note holders to be converted into common, prevent further participation/investment of those noteholders or in some instances just pay back the convertibles notes and prevent the conversion entirely. In many instances, we have seen Series A terms that waive the discount on the convertible note. Entrepreneurs are put in a tricky position that pits them against their earlier investors as not accepting modifications to the convertible note which may put their financing at risk. And on the investor side, those terms could be disastrous for investment and could pit them against the entrepreneur. It is not just about priced round versus convertible notes it is about the investor.
We at Launch are increasingly bullish on the value of pricing a round versus a note. Of course there is a financing amount threshold amount that is part of this that varies situation to situation. We believe that a raise of >$250k and above makes a priced round the best practice. The convertible note versus priced round debate is that generalized advice is very different from the proposal of specific investor. A lot of what a convertible note represents is protection for an entrepreneur from bad terms, and unnecessarily high legal costs. The majority of the problems with priced rounds are because an entrepreneur is dealing with a bad investor not an inherently flawed legal document. Priced rounds are valuable when an entrepreneur is working with an investor they are excited to partner with and we hope to be that partner.