There was a time when the term "unicorn" was made solely with reference to halloween costumes, where "angels" referred to cloud-piercing biblical figures (or perhaps a good Dan Brown novel), and where "seed rounds" were more likely to elicit excitement at your local farmer's market, as opposed to any self-respecting Patagonia-clad venture capitalist.
The author and his own unicorn start-up, circa Halloween 2016
For tech founders however, angel investors and the seed financing that they provide are the first source of external funding for their business. Indeed, putting ink to paper on that very first seed round is what dreams of building the next unicorn startup are made of.
The Rise of Free Resources
As start-up culture entered our mainstream conscious, so too has the democratization of free legal resources. Institutions like Y-Combinator, MaRS and law firms like Cooley now publish legal agreements for free use and distribution, especially where it concerns raising seed financing.
By and large, my view is that this phenomenon as a positive one. At the seed stage, the venture ecosystem is better primed for growth where legal advice is transparent and packaged for mass-consumption. Indeed, the universe of founders far exceed the number of good solicitors eager to service them (I promise). Moreover, burn-rate is top of mind for founders, and the importance of building a minimally viable product should rightfully absorb more time, attention and cash than their legal fees. Indeed, had the Wright brothers brought some extra baggage along for their first flight, it might never have left the ground at Kitty Hawk.
Decidedly baggage-light
However, reflecting on my own experience working with founders, my opinion is that these freely available financing templates are not always something founders should blindly take off the shelf, polish-off and sign.
Indeed, founders should carefully consider the structure of these seed financing agreements, what terms are actually being agreed to.
What's in a Seed Round?
These days, seed rounds may encompass any amount of start-up capital ranging from tens of thousands up to a few million dollars. Seed rounds are frequently provided by angel investors (often a high-net worth individual) to help the business get off the ground. Businesses will use their seed round to gain traction, garner user data, demonstrate a use case, or to help craft a minimally viable product to launch to market. The goal is then typically to raise a larger Series A round to help scale the business.
Seed. Round.
The angel investor's reward hinges on taking an ownership stake in the founder's business, with an eye towards the company's continued success, an increasing valuation, and a future liquidity event.
Googling Your Way to Glory
Frequently, I've seen angel investors come armed with his or her own preferred seed round agreement, which they will happily whip out while cutting you a cheque at Starbucks. Alternatively, they may ask the founder to provide their own financing template for consideration. This is typically the step where a young founder will start googling and hunting down a free seed financing template online.
Don't get me wrong, I love google. In fact, this author himself has googled his way into a number of answers for life's tough questions (special shout out to WebMD). However, the successful founder needs to understand what she is bargaining for - indeed, each of these agreements bring with them their own set of pros, cons and quirks.
Founders should take the details seriously, and to seize the opportunity to customize each agreement where necessary. Common types of seed financing structures include convertible notes, SAFE agreements, and preferred stock agreements.
The Old School - The Convertible Note
The most frequently used instrument for raising capital at the seed stage is the convertible note. Experienced and sophisticated angel investors will be familiar with it. Founders should as well.
Convertible notes are debt instruments that carry a maturity date and give the angel investor a right to principal and interest payments. Of course, investors don't make their money off principal or interest payments - they're not a bank lender, and in any event, that is not where they will amplify their returns.
Rather, the goal of the angel is to convert the note into equity alongside a Series A investor, usually an institutional investor like a venture capital firm. These convertible notes are sometimes referred to as "unpriced equity" - the reason being that the angel investor will figure out what percentage of equity their note will convert to when a determination as to valuation is made in the Series A round down the line.
A mistake founders make with convertible notes is to focus too much time and attention on negotiating interest rates and maturity dates. As opposed to interest rates, investors know that the conversion price is actually a more material term. Likewise, investors have little to gain from demanding principal payments upon maturity if the business is not successful in a few years.
Instead, what founders should carefully review are the conversion features of any convertible note, as those are the mechanisms by which the angel investor will eventually become stockholders in their company.
First, founders should consider the dollar threshold of investment will trigger a conversion of the note. If this threshold is too low, then the angel investor might convert to being a shareholder in the company much earlier than expected upon raising additional seed-stage financing. If this threshold is too high, then the angel investor may be dissuaded from investing if there is no prospect of their note converting to equity. Founders should give thought to what size of Series A investment is achievable for start-ups in their category.
Second, founders should consider what discount to grant angel investors. Since angel investors are the first "at-risk" sum of money given to the business, angel's typically expect to be compensated for shouldering more risk than the Series A investor.
Discounts come in a number of flavours. Discounts can be given (i) as a straight percentage discount (typically 20%) upon conversion to equity and/or (ii) as a "ceiling" on the company valuation upon conversion to equity (i.e. if the company is valued at $20 million by a Series A investment, the angel investor will be allowed to convert their note as if the company was valued at a cap of $15 million - representing a 25% discount in this example).
The goal here is to reward the angel investor appropriately, without granting such a sweet deal that a future Series A investor would be skeptical of it.
The New School - The SAFE Agreement
Simple Agreements for Future Equity (or SAFEs) have also risen in popularity since being introduced by Silicon Valley's Y-Combinator. I have seen them used to fund Canadian start-ups, not uncommonly as a number of SAFEs that provide financing in aggregate. There is also a very similar agreement called Keep it Simple Security (KISS agreements) popularized by the venture fund 500 Startups.
Essentially, SAFEs are option agreements - a piece of paper that entitles the angel investor to claim equity in the company at a future date. Much like a convertible note, the SAFE will specify what the conversion events will be (typically an equity financing or corporation transaction). Also like a convertible note, the SAFE will provide a discount rate or valuation cap to the angel investor as an incentive.
Unlike a convertible note however, SAFEs are not debt, and thus do not include the concept of maturity dates and interest payments. Therefore, this does not force the company to bump up against maturity dates that may prompt re-negotiations with the angel investor. Likewise, this also makes SAFE agreements much shorter and simpler than a convertible note.
Since there are no maturity dates, SAFE agreements can technically be held indefinitely by the investor. Because SAFEs are also shorter and simpler than convertible notes, they are often signed in quick succession to provide aggregate amounts of financing (5 separate SAFEs each totalling $50,000 for financing of $250,000 for example). However, this could lead to greater cost and complexity in the next financing round if many SAFEs are converted at once. Founders need to keep an up-to-date capitalization table showing "who will own exactly what % of the business" when they are pitching for Series A funding.
Lastly, some thought should be given to who your SAFE investors are and what their backgrounds and personalities are like. Founders need to be particularly aware if different discount terms are being given to different investors. Those investors may be forced into renegotiations if the venture capital firm leading the next equity financing round requires certain concessions from those SAFE investors. This might entail some unwanted wrangling at a critical time for the founder - best avoided.
The Alternative - Preferred Stock
Lastly, founders may directly sell preferred stock to the angel investor. Unlike convertible notes or SAFEs, a sale of preferred stock gives the angel investor control over the negotiation of the price and terms of the stock at the time of the investment. For the founder, structuring a seed investment using preferred stock also allows them to know exactly how much of the company they own immediately after the financing closes.
Unlike convertible notes or SAFEs, founders should note that preferred stockholders are typically given contractual rights or protections (which could include board rights, the right to regularly receive financial information, the right to receive dividends etc.) and an option to convert their preferred shares to common shares. If the company does poorly, convertible preferred stockholders do not have to convert their shares to common stocks. Then, if the company goes bankrupt, they will be paid from whatever assets remain before common shareholders get a chance.
As such, selling preferred stock is usually more complicated than executing a convertible note or SAFE, and could require more negotiations around shareholder rights and increased expenses from having to amend parts of the company's articles or bylaws, which would require fees and likely legal advice.
Wrapping It Up
Founders take note! While there are plenty of good seed financing templates, they shouldn't be treated like the iTunes Terms and Conditions section (or an assigned reading in 3L of law school) - they need to be read and they need to be understood.
Where appropriate, seek an opportunity to customize terms, or indeed insist on a different type of seed financing structure, if necessary.
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