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An In-House Counsel’s Guide to Startup Seed Financing

Raising capital in the initial phase of a startup’s journey can be challenging and rewarding. Known as seed financing, this early-stage round is typically supported by friends, family, and high-net-worth angel investors. It is the first and often most vital round of financing for a startup. It enables the startup to turn a novel concept into an operational business.

Photo by Francesco Gallarotti on Unsplash

While many startups have not hired in-house counsel at this point, the guidance of a skilled lawyer can make the difference for successfully navigating a seed financing round. Sound legal advice can help a seed-stage startup select the right financing instrument for raising capital and identify key considerations with respect to the company’s unique development trajectory.

Phases of a Startup’s Lifecycle

The lifecycle of a typical startup can be broken into four distinct phases:

  • Idea/Concept Stage: This initial phase involves creating a rough prototype or basic version of an initial idea to share with close circle of trusted friends and advisors.
  • Building: This next phase is dedicated to raising additional capital, hiring more employees, and building the basic prototype of the product or service into something that could be released to the public.
  • Scaling: The focus shifts in the scaling phase to expanding customer reach and capturing additional market share.
  • Maturity: Once the company approaches maturity, it turns its concentration to attaining profitability. However, many venture-backed startups are still unprofitable by the time they are sold or go public via an initial public offering (IPO).

While each startup faces unique circumstances, the successive financing rounds are typically labelled Series Seed, Series A, Series B, Series C, Series D, and so on.

 

Seed Stage Round

The first round of financing that a startup completes is called the seed round. This initial round usually relies largely on investments from friends, family, and angel investors. During the seed round, the startup has generally not reached a level of viability that would attract institutional investors yet.

In seed financings, companies usually raise somewhere between $50,000 to $2 million. Seed-stage companies usually issue either convertible notes or simple agreements for future equity (SAFEs). Less commonly, seed-stage companies will issue convertible preferred stock.

Convertible Notes

Convertible notes are the most frequently used instrument in seed financings. They are debt securities that are characterized by the following features:

  • A principal amount that is due at a maturity date
  • A fixed interest rate
  • The eventual conversion of the debt into preferred equity
  • A pari passu ranking with all other unsecured non-senior debt

Once the occurrence of certain events, convertible notes convert into different types of equity. These events include:

  • Next Equity Financing conversion: The most common trigger for a convertible note conversion is a subsequent preferred stock financing. This is referred to as a Next Equity Financing.
  • Corporate Transaction conversion: This convertible note conversion is triggered by the sale of the company while the notes are still outstanding.
  • Maturity conversion: In circumstances where the company has reached a specified maturity date, but neither a Next Equity Financing or a Corporate Transaction conversion has not occurred, a convertible note conversion can be triggered.

When a conversion occurs, the holders of convertible notes often receive equity at a discounted price as compared to the price paid by new equity investors. Stated differently, the notes will convert at a per share price that is lower than the per share price of the preferred stock the company is issuing to new investors in its subsequent financing round.

Simple Agreement for Future Equity (SAFE)

The SAFE is another popular seed financing instrument. The SAFE has identical conversion features as convertible notes, except for the main distinguishing features:

  • No maturity date: the SAFE remains outstanding indefinitely until a conversion event takes place
  • No accruing interest: interest does not accrue on the principal amount

The SAFE was developed by Y Combinator, the prominent Silicon Valley startup accelerator. Startup founders sometimes find the SAFE to be a more attractive tool than issuing convertible notes.  For example, the company’s founders want to avoid finding themselves in a situation where they have issued convertible notes and reach the maturity date without having concluded a subsequent round of financing. Once the maturity date expires, the holders of the convertible notes may be able to extract more favorable terms from the company in exchange for the company negotiating an extension.

Convertible Preferred Stock

Convertible preferred stock is a more commonly used instrument in later-stage financing rounds that involve raising capital from institutional investors. In seed financings, convertible notes or the SAFE are the most commonly used instruments. This is partly because preferred stock terms are more complex to negotiate. This makes them less user-friendly to unsophisticated seed investors and may increase the length of the negotiations.

When convertible preferred stock is issued in a seed round, it is often referred to as Series Seed preferred stock. Certain rights, preferences, and privileges are granted to holders of preferred stock.

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