The financial burden of transporting an idea from initial discovery through proof of concept, optimization and testing, and into commercialization can be significant. Some fortunate entrepreneurs can tap close friends and family for capital to supplement their own contributions of cash and sweat equity. When friends and family capital is not available, or runs out, entrepreneurs and their start-up enterprise may decide to seek “Seed” capital to continue the path toward launch.
Seed capital is early-stage financing received from venture capital firms or other private investors in what is referred to as a “Seed Round” or “Series Seed” due to its application in the company’s early stage of life. Seed Round financing typically ranges from $50,000 to $2 million and is intended to fuel 12-24 months of operational capital to enable the enterprise to demonstrate its technical and team capabilities, prove its concept to potential customers, and develop interest and excitement from potential investors to raise the next round of capital.
Seed capital is typically provided to an enterprise through a “convertible securities” structure. Convertible securities allow investors to infuse cash into an enterprise in exchange for the ability to have their investment converted into equity interests (ownership) in the enterprise at a future date or upon the occurrence of a future event. The most common forms of convertible securities are convertible notes and SAFEs (simple agreements for future equity). A convertible note is a loan by an investor that converts into equity in the enterprise upon certain future events, usually additional financing rounds, a sale, or public offering. A SAFE is an agreement between an investor and the enterprise that provides the investor with rights to future equity in the Company in exchange for upfront cash. The key differences between the two instruments include the fact that a SAFE is not a loan, so a SAFE will not have a maturity date and no interest will accrue on the principal. While both instruments are non-dilutive at first, they both will cause founder dilution upon conversion, which ultimately diminishes the founder’s share of enterprise growth and control over the business.
In both instruments, key terms include the type and triggering mechanics of the conversion events (what triggers conversion of the principal of the instrument to equity), the “valuation cap,” and the “conversion discount.” Triggering mechanics related to a future financing, change of control transaction or liquidation event are typically heavily scrutinized. The valuation cap sets a maximum valuation (for the purpose of determining the price per share) at which an investor’s money converts into equity at the next financing round. This term is designed to reward investors with more equity by keeping the conversion price down if the enterprise’s valuation grows quickly. The conversion discount gives investors a discount on the price per share—compared to other investors buying shares in the subsequent financing round—when their instrument converts into equity.
While this content is very technical and novel to many early-stage entrepreneurs, both instruments have fairly standardized forms in the seed financing marketplace. As long as the parties collaborate effectively on a term sheet, which is usually the first step, either instrument can be drafted and negotiated efficiently and affordably (with significantly less investment in outside professionals than a formal equity raise) enabling the necessary infusion to launch the big idea at a reasonable cost.
For additional information, please contact Kent Bednarz: kbednarz@wolfsonbolton.com, (248) 247-7102.
