Thoughts on startups by investors that
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Series Seed or Convertible Note? Which one is more founder friendly? Which one do investors prefer?

There is not a definitive answer to this, because a good lawyer can write terms into either one to make one or the other preferable to one or the other party.

That said, the primary entrepreneur-friendly reason for doing a Convertible Note (and the reason that no serious investor under regular circumstances will therefore do an uncapped note) is:

The valuation negotiation is put off until the next round. Assuming the company is able to make effective use of the seed money to greatly increase the value of the enterprise, all of that value therefore accrues to the founder, rather than the investor. The discount to the next round the investor receives in a typical Convertible Note is usually nowhere near as advantageous as investing at a fixed, lower valuation would have been.

For example, let’s say the “real” value of a startup is $900,000, a seed investor puts in $100,000 on a Convertible Note with a 20% discount, and the company then raises a Series A round of $1 million at a $4 million ‘pre-money’ valuation. Under the note scenario, the investor’s “gain” after the Series A would be the difference between investing at the $4 million valuation paid by the Series A investor, and investing at the $3.2 million valuation provided by the 20% discount of the note. That is, for a $100K investment, a difference of $20,000.

On the other hand, if the investor had put the $100,000 into the company in a Series Seed Convertible Preferred round, the investor’s “gain” after the Series A would be the difference between the investor’s 10% ownership at the $4 million valuation ($400,000) and the original $100K purchase price, which works out to $300,000. That is a swing of 15x from the investor’s point of view! Because the investor is putting in the seed money where the later stage investor won’t take the risk (“angels rush in where VCs fear to tread”) the investor rightly figures that the reward should be commensurate with the risk.

Note: The one significant exception to this is that Friends & Family seed rounds are usually done as Convertible Notes with a Cap, because in the absence of a professional investor (such as a serious angel or an early stage VC) the extreme likelihood is that both sides will price the deal incorrectly, and will thus cause significant problems down the road when the first arms-length investors try to fund.

The other factors bearing on the advisability of doing a convertible note are that it is debt, not equity (good for the investor, because in a down liquidation scenario the note gets paid out ahead of anything going to the founder; bad for the investor, because in an up liquidation scenario prior to conversion, the company can just pay off the note with interest, and avoid giving the investor any upside); that it is significantly less expensive (the cost for the lawyers on each side to paper a convertible note (assuming a relatively new company with nothing funky going on) can be as low as a few thousand dollars each. In contrast, doing a full Series A round might be $25,000 – $30,000 each, and even a Series Seed might be $10,000 each); that it typically provides many fewer rights and protections for investors; and that while everyone investing in a Series Seed round will be investing on the same terms at the same valuation, with a series of Convertible Notes a company can choose to raise money at different valuations from different investors.

Over the past 20 years, the “standard” terms for typical seed/angel deals have gone from Common Stock (mid-90’s), to Convertible Notes (late 90’s through early 00’s), to full Series A Convertible Preferred (mid 00’s), to Convertible Notes with a Cap (late 00’s), to Series Seed or similar (present). This represents the increasing sophistication of both investors and entrepreneurs, the increasing experience and publicity surrounding the advantages/disadvantages of various options, and the increasing availability of model documents and online generators for the different choices.

*original post can be found on Quora @ http://www.quora.com/David-S-Rose/answers *

Written by David S. Rose

user David S. Rose Founder and CEO,
Gust

David has been described as "the Father of Angel Investing in New York" by Crain's New York Business, & a "world conquering entrepreneur" by BusinessWeek. He is a serial entrepreneur & Inc 500 CEO who chairs New York Angels, one of the most active angel investment groups. David is also CEO of Gust.

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