Startups often raise their seed round by selling convertible debt instead of equity because debt is simpler and cheaper. Read Yokum Taku’s excellent series on convertible debt for a primer.
Seed stage convertible debt agreements are fairly simple, especially if your investors are angels. There isn’t a lot to hack into these agreements. You should be more careful if your debt investors are VCs, but these debt financings are still much easier to negotiate than equity financing.
Later stage convertible debt can get complicated and adversarial. We know companies that took convertible debt from a corporate investor and couldn’t pay the debt back on time—which triggered the corporate investor’s right to take over the company. Fun stuff.
If you are raising convertible debt, you should focus on negotiating simple and short documents, closing quickly and cheaply, and maintaining your options for Series A. But first…
Determine whether you should sell debt or equity.
Let’s say your seed investors purchase debt with a 20% discount off the Series A share price. If you eventually sell shares in Series A for $1 each, the seed investors will convert their debt to equity for $0.80/share.
Now, let’s say your seed investors are willing to buy equity for $0.90/share instead of buying debt. Should you sell debt or equity?
You should sell debt only if you can use the money to increase today’s share price by over 25% before the Series A financing. Otherwise, sell equity.
In this example, debt is worthwhile if you think you can sell Series A shares for over $0.90/share × 125% = $1.125/share.
Let’s say you decide to sell debt in your seed round and you raise a Series A at $2/share. After applying a 20% discount, your debt investors pay $1.60/share for their Series A shares. You were wise to sell debt to your seed investors in the seed round instead of selling them equity for $0.90/share.
But if you raise a Series A at $1/share, your debt investors pay $0.80/share for their Series A shares. You should have taken their offer to buy equity at $0.90/share in the seed round.
In general, you should sell debt only if you think it will increase your share price over today’s market price for your shares ÷ (1 – discount).
Selling debt is usually better than selling equity in a typical seed round.
If you are raising a typical seed round, say $50K-$500K, you probably want to sell debt instead of equity. If you raise enough seed debt to last 6-12 months, you should have enough time to increase your valuation by the 25%-100% required to overcome typical discounts of 20%-50%.
For example, if you raise $250K in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $1.42M. You should raise debt instead if you expect your Series A pre-money valuation to be at least
$1.42M ÷ (1 – .2) = $1.77M (in the case of a 20% discount)
$1.42M ÷ (1 – .5) = $2.83M (in the case of a 50% discount).
In general, if you don’t think you can increase your share price and valuation by 2 to 3 times in every round of financing from Series A to Series C, you should probably pack up and go home. In fact, the company’s share price typically increases the most from the seed round to the Series A as the business goes from nothingness to product, users, or revenue.
Selling lots of debt may be worse than selling equity.
If you are raising a large seed round, say $1M, you may want to sell equity instead of debt.
For example, if you raise $1M in a seed round in return for 15% of your equity, your seed round pre-money valuation will be $5.67M. But if you raise $1M in return for debt at a 25% discount, your Series A pre-money will have to be at least
$5.67M ÷ (1 – .25) = $7.56M
for the debt to be worthwhile. $1M of seed financing may not take your Series A valuation above $7.56M—you may want to sell equity instead of debt in the seed round.