As we’ve prepared to fundraise for Catapulter, we’ve found that it’s very difficult to find the right resources on what exactly are the key questions and negotiating points in raising a seed round.
Fundraising at this early stage is quite complex for someone who hasn’t been there before, and I’ve found a very good selection of resources that I’d like to share.
In addition, sometimes, you just want to get a few datapoints on typical terms, but many bloggers are hesitant to put their foot down. Below, I’ll give a few datapoints from my research – but please note, these are single datapoints to be taken among many.
THE FIRST QUESTION: EQUITY OR CONVERTIBLE DEBT
Many first-time entrepreneurs assume that all investment is done with equity. However, a relatively new and increasingly popular investment instrument is Convertible Debt, with Paul Graham of Y-Combinator famously tweeting this summer:
“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
As a result, I’ll focus a bit more of this post on convertible debt.
Equity investment is an investor purchasing a percentage ownership of your company. In order to do this, you need to value your company. There are a number of ways to value the company, but at the very early stages, you’re likely going to be looking at valuations and investments in similar companies to yours, adjusted by your experience (first time entrepreneur vs. sold two companies to Google) and the competitiveness of the deal (one investor vs. ten investors interested).
Financial models may be used as triangulation, but are generally less useful because of the huge volatility of companies at such an early stage. Early stage valuation is mainly figuring out the market value – not the intrinsic value – of your startup.
A couple of points to remember:
- Valuation is not the only issue
- When doing an equity deal, other terms included in the term sheet (the document containing the deal terms you’ll negotiate over) can create major shifts in value between the entrepreneur and investor. See the section on equity term sheets later in the post
- Know the difference between pre- and post-money valuation
- If an investor is putting in $500k, and your company is valued at $2M pre-money (before investment comes in), that would mean the investor is buying 25% of the equity of your company
- If you’re valued at $2M post-money, that means your business is worth $1.5M pre-money + $500k in cash you’re about to receive. Therefore, the investor would receive 33% of your company
- In a seed stage investment round, make sure you understand typical comparable terms, and whether they are pre- or post-money
I find the easiest way to define Convertible Debt is with an example:
Let’s say Angel Allan is investing $20,000 in your company, AwesomeCo, with Convertible Debt. Allan will give AwesomeCo $20,000 as debt, hence AwesomeCo owes him $20,000. When AwesomeCo decides to raise its next round of investment, say its first full Seed Round, it will be given some valuation (pre-money) by investors, say $2M. At that point, Allan will convert his debt into equity by applying that $20,000 to the $2M valuation. $20,000/$2M = 1% equity stake.
Because Allan is only getting the same valuation as the new investors, even though he put in money earlier (i.e. with higher risk), there are two ways to help compensate him for this risk:
- Discount – If Allan got a 10% discount, he would get to buy into the next round for (1-10%) = 90% the price that investors without a discount pay.
- Another way to say this is to buy $1 worth of equity, Allan would pay: [$ Allan Pays] = (90%)*($1).
- Rearranging the equation, we can see that Allan’s dollars are worth $1/$0.90 = 1.11 times what another investor’s dollar is worth. Therefore, he’ll get a ($20,000 * 1.11)/$2M = 1.11% stake upon conversion.
- Valuation Cap – If Allan had a valuation cap on his convertible debt, the valuation (currently $2M) at which he converts would be limited. Obviously, the lower the valuation cap, the better Allan does. If the valuation cap was $1M, he would get a $20,000/$1M = 2% equity stake, even though other investors value the company at $2M.
Generally, an investor will get one of these terms, not both. I’ll discuss terms in more detail later.
Many major blogger-investors seem to be split on the matter. Here are a number of blog posts on the issue by folks who know a lot more than me:
- Seth Levine – Managing Director at Foundry Group: http://www.sethlevine.com/wp/2010/08/has-convertible-debt-won-and-if-it-has-is-that-a-good-thing
- Fred Wilson – Union Square Ventures: http://www.avc.com/a_vc/2010/08/some-thoughts-on-convertible-debt.html
- Mark Suster – Partner at GRP Partners – Good Pros and Cons: http://www.bothsidesofthetable.com/2010/08/30/is-convertible-debt-preferable-to-equity/
- Chris Dixon – CEO/Founder of Hunch: http://cdixon.org/2010/08/31/converts-versus-equity-deals/
- Video: http://techcrunch.com/2010/09/10/super-angelvc-smackdown-whats-so-great-about-convertible-debt/
My takeaways on convertible debt have so far been the following:
- Avoids pricing the company – good because:
- Round goes quicker because less haggling over pricing
- Valuation at early stage can be too low (leading investors in next round to demand too low a price)
- Valuation at early stage can be too high (next round could be a “down round”, another bad signal to investors)
- Since investor does not get equity until next round, they are included in the same “tranche” of equity as investors in next round
- Having own tranche could give undue veto power in some circumstances
- Convertible debt takes away some upside for investors
- This can be mitigated somewhat with Discount or Cap
- Unfortunately, Cap can be interpreted similar to pricing a round
Like Paul Graham and Y-Combinator, our incubator has suggested we raise convertible debt.
TYPICAL TERMS FOR CONVERTIBLE DEBT vs. EQUITY DEALS
Typical Convertible Debt Terms
- Discount – From 10-40%
- Valuation Cap – From ~$2-$9M, highly dependent on founders’ experience and track record
- First time entrepreneurs can expect the lower end, if you’ve sold 2 companies to Google you can expect the higher end
The most reputable source I’ve seen is this response, from a VC on Quora. Be sure to check the comments/responses to see all of the details: http://www.quora.com/For-convertible-notes-what-are-typical-discount-rates-and-caps-for-startups-that-are-pre-launch
In addition, it’s important to note that there will be a difference between convertible debt from a sophisticated investor and from Friends & Family. It’s good to take Friends & Family money with convertible debt to avoid pricing the round, and give a discount, not a cap (as this will be treated by later investors as similar to pricing a round).
Typical Equity Term Sheets
For equity, here are some resources and standard term sheets released by top incubator programs that can be used as guidance. There are many more terms you need to be careful about, and even reading the articles below, it is difficult to catch all of the nuances without having been through it. You should absolutely consult a lawyer and other experienced fundraisers before raising money.
- Chris Dixon’s Ideal First Round Term Sheet:
- TechStars Series A:
- Y-Combinator Series A: http://ycombinator.com/seriesaa.html
- More suggestions from OnStartups:
THE IMPLICATIONS OF CORPORATE STRUCTURE FOR A STARTUP (C-Corp vs. LLC)
While I won’t go into extreme detail here, it’s important to note that before you raise money, you’ll need to create an official business entity for your company. There is a significant tax advantage to creating your company as an LLC vs. a C-Corp. However, if you’re raising VC money, you’ll most likely need to be a C-Corp.
The main issue to understand is that profits from an LLC are passed directly from a company to the owners (“members”) before tax, and taxes are applied to the members at the personal income tax level. Profits from a C-Corp are taxed within the corporation at the corporate level, then taxed AGAIN at the personal income tax level when distributed to shareholders (investors/founders) as dividends.
The next important point is that most startup acquisitions occur as asset sales, not stock sales. Therefore, when you sell your company to Google, they don’t buy your shares and leave. They don’t want to take on every liability you’ve ever created, especially those you may have no idea about based on something you did in the early days of your company that you thought was legal. They will typically purchase the desired assets (IP, key personnel, etc.) from your company and leave the junk and unknown liabilities behind. Therefore, for a C-Corp, the “sale price” is taken as income (from an asset sale) to the company and taxed at the corporate rate, and the only way the shareholders (including you, the founder) can get this money in their pockets is by distributing it as a dividend, which is taxed A SECOND TIME at the personal income tax rate. For an LLC, profits from an asset sale would pass directly to the members, and be taxed a single time at the personal income tax rate.
This would suggest startups form as LLCs…unfortunately, VCs typically will only invest in C-Corps. This is because the entities that fund VCs demand it.
In short, many of the entities that give VC funds money to invest are non-profits (e.g. college endowments or state pension funds). By investing in a VC fund, these non-profits are “owners” of the fund’s portfolio companies. Since earnings from a for-profit LLC are passed directly to owners BEFORE tax, the endowment or pension fund would be making money, without paying tax, from a for-profit business. As a result those companies would have an unfair advantage vs. for-profit companies that do pay taxes, and hence the government can revoke the endowment or pension fund’s non-profit, tax-free status. Since a C-Corp is taxed within the company before profits are distributed to shareholders, this issue does not arise with C-Corps.
Though you may not have much of a choice, it is important to speak to a lawyer before you select whether your company will be an LLC or C-Corp. I wanted to flag this issue, since a C-Corp can lose a lot of value for a founder/shareholder through taxes, but there are also many other nuances that are important to understand before making this decision.
Please note: I wrote this post to be a starting point for someone raising a Seed Round. I am not a lawyer, nor an expert on fundraising.
Before you raise money:
- Get a lawyer
- Talk to more entrepreneurs and investors
- Read the articles I’ve linked to (among others)