Ask the Expert: How do you select the best seed round structure for your startup?

Starting a business is exciting, but often comes with many risks and uncertainties. For most entrepreneurs, having a trusted resource to go to when problems arise can often be the very element needed to achieve game changing success.
Launch DFW is thrilled to kick-off “Ask the Expert”, a new biweekly segment that invites North Texas industry thought leaders to share helpful advice and strategies with current and aspiring business owners.

Meet Startup Lawyer Ryan Roberts

Ryan Roberts is a partner of Roberts Foster LLP as well as the author of the startup blog “Startup Lawyer“. Roberts represents startups as they navigate grey areas such as investments and acquisitions and also represents venture capital funds in their investments.
Roberts has agreed to give us a sneak peak of his forthcoming book titled “Acceleration: What All Founders Must Know About Startup Law”. The excerpt focuses on the dynamics of selecting the proper seed round structure for your startup. Subscribe to his blog to stay up-to-date with Ryan and to get a copy of his book later this year.

Selecting Seed Round Structure

How do you decide what the best seed round structure is for your startup? The only real rule regarding seed round structure is: Select the structure which allows your startup to close.

Don’t over think it. Don’t succumb to groupthink. Close the deal.

But if your startup is lucky enough to have a choice of investment structure, what’s been preferable for a startup (in descending order) is:

  1. Convertible equity (i.e., SAFEs)
  2. Convertible debt
  3. Preferred stock

Some may argue that convertible notes are less favorable to startups than preferred stock. It really depends on what happens down the road with the company. I don’t think there is ever a wrong answer going into the actual deal, and hindsight is 20-10 in the startup world.

For some startups that go with a convertible debt round over a priced equity round, the gamble on the ultimate valuation of the convertible debt (that is, on a convertible debt round there is usually no technical valuation agreed to at such time) will be worth the reduced (or non-existent!) amount of investor control rights relative to what is normally exhibited in a preferred stock round.  In many scenarios, agreement on a price cap for a convertible debt round doesn’t necessarily mean that the startup could have closed a preferred stock round at a valuation equal to the price cap of the convertible debt.  In many circumstances, the price cap that a startup can close a convertible debt round will be higher than the valuation it could close a preferred stock round at the same time. And this is especially the case in areas outside of Silicon Valley.

Thus, the convertible debt instead of preferred stock gamble can pay off when the startup is able to raise a subsequent equity round at a valuation that converts the convertible debt at the “price cap” (the highest pre-money valuation at which the convertible note may convert).

In the startup world, we get a lot of one-off stories of, “Hey, this didn’t work and therefore you should never use this type of structure.” So many variables are at play in each particular instance that you can’t disqualify an investment vehicle just because one or two cars crash. No matter what structure you choose, it’s a gamble.

Sometimes, it wasn’t the investment structure that killed the company. It could have been the founders or the investors or both. It’s unwise to fully throw something aside because of one or two stories you read or hear about. Assigning proximate cause to failure is difficult and investment structure will not likely be high on the list.

And don’t fall into the “above $1 million do this/below $1 million do that” trap. For a while, it was trendy to issue convertible notes if your seed round was under $1 million and use preferred stock for anything above $1 million. But, I’ve worked on seed rounds of $2 million to $5 million that feature convertible-notes and preferred rounds under $1 million. And guess what, those rounds ended up not harming the startup. Startup investment structure is not binary.

While there is no distinct financial tipping point that makes a different type of seed-round structure a better fit, if you’re adamant about raising a subsequent round, then convertible instruments—whether that’s convertible equity or a convertible note—might make more sense. If you’re not planning to raise a second round, then you likely shouldn’t use a convertible instrument. Convertible equity and convertible debt are structured to be used in conjunction with a second round, the true definition of a “bridge financing”. Therefore, if you raise a seed round of convertible debt or convertible equity without plans for a subsequent round, you’ve just raised a “bridge to nowhere financing”.

There is no such thing as the one and only perfect seed round structure, and there will certainly be trendy investment structures that come and go. The key is to adapt to your investors and close the round. And realize that any structure can be made to be either investor-favorable, company-favorable, or neutral.

Have a Question?

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