In your free time, while not grinding away at your corporate day job, you’ve developed an early-stage version of an application that allows users to chase small digital emojis around town while staring at a smart phone. You’re confident it’s the next big thing, and the opportunities to monetize are endless. The problem: you’re not independently wealthy and the Powerball odds are awful. Thus, the hunt for capital begins…

Often, the first place founders look for cash is from friends, family and their professional network. Incubators, accelerators and “angel” investors may also be sources of initial seed funding. In any event, the discussion with any potential investor quickly turns to how they will put their money in, and what they will receive in return. In exchange for their cash, investors can receive common or preferred stock (or units if the entity is a limited liability company). Common stock brings the highest risk for the investor as they could lose their entire investment should the company fail. Less risky is preferred stock that carries certain rights and privileges not associated with common stock. Such rights may include a preference on distributions of profits, preference to receive payment ahead of other equity owners upon liquidation, and perhaps a guaranteed rate of return over a stated period of time. Common and Preferred stock owners are shareholders of the startup, and have all the rights (and potential headaches) that traditionally come with that moniker.

A useful alternative to standard equity in early stage investment is convertible debt. Key features of convertible debt are: (1) principal amounts that are due at a maturity date; (2) a fixed rate at which interest accrues on the principal balance; and (3) a claim on the company’s assets that is senior to all equity holders, but junior to any bank or other secured debt. 

Convertible notes are fairly straight forward for founders and investors with only a handful of negotiated terms: maturity date, interest rate, conversion discount, and valuation cap. Typically, the investor/noteholder will receive the same ownership that a venture capital firm investor negotiates in the next financing round, but at a discounted price as a reward for investing early through the note. Importantly, it can be less awkward to issue convertible notes to close friends and family, because the valuation negotiation is deferred until the next round of financing, which will likely include a professional venture capital firm.

Sounds perfect, right? Well, there are a few hang-ups with convertible notes.  Most notable (pun intended) neither the investor nor the founder knows exactly what percentage of the company they own while the notes remain outstanding. To partially remedy this issue, convertible notes may contain a valuation cap so investors and the company have an idea of the highest valuation at which the notes may convert. However, these valuation caps often become part of the negotiation with professional investors in the next round of financing. A final knock on convertible debt is…its debt. If the notes reach maturity before conversion, and the company doesn’t have the cash to repay the notes plus interest, the investors may be able to leverage additional concessions in exchange for an extension of their notes.

There are many considerations when navigating early-stage seed investments from valuation concerns to guaranteed returns to management and voting rights. Depending on the situation and the amount of money being raised, convertible debt may be a good option for seed investments from friends and family. Of course, as any good corporate lawyer will tell you, you should always consult with counsel before getting too deep into the first round of investment. We can help structure the financing in the most efficient way possible with an eye toward the next round and beyond.