The first few funding rounds of capital are very awkward for a company. They don’t have cash or they would not need investment. They don’t have revenue to justify any meaningful valuation. They don’t have clients or purchase orders to use as credibility or for financing. Thus, Angels fund the gap between opportunity and viability. The perennial question is what is the best way to do so and how do we ensure that we are compensated for our risk without hindering the company’s ability to move in the marketplace with both clients and investors?Most early stage companies want to put off deciding on an enterprise value, or valuation, as long as possible. They are misguided in this pursuit, but they do so nonetheless. Some fear giving up too much control. Others fear dilution. Others fear that by pricing the company now, it will affect future valuations. In reality, none of these are true if both entrepreneurs and investors seek a fair valuation. Investors will always seek a lower valuation than the entrepreneur wishes, but that is the classical battle between the realist and the optimist.

Several vehicles are available for “Seed” deals: convertible notes, SAFE notes, revenue sharing, custom equity (which we don’t recommend due to cost and need to harmonize future rounds of capital), and Series Seed. There are three types of vehicles here: debt (convertible to equity), equity (custom closing docs, SAFE notes, and Series Seed), and the good old standby, the revenue sharing deal.

The Series Seed vehicle/set of closing documents is an equity deal. Essentially, the Series Seed vehicle is Series A lite with a twist. It mimics the convertible note in many ways, except that a true class of stock is created within the company’s Charter and issued to the investor(s). It contains many of the important features of a Series A, but with considerably lower cost and overhead, meaning the company will pay $5,000 – $10,000 in legal fees, which is generally considerably cheaper than a full Series A, which will cost the company $10,000 – $25,000. The company must create a class of stock, Series Seed Stock, that is issued to the investor at a given valuation. When the next qualified round (typically $1M+ in equity) is closed, the Series Seed Stock automatically assumes the rights of the new preferred stock. The Series Seed vehicle is the equity version of a convertible note except the discount is not guaranteed since the valuation is already fixed. It is worth mentioning that the gains associated with a debt discount of a convertible note are in reality only “paper-based.” On the positive side, the Series Seed stock does not become a long term liability on the books of the company as with the convertible note. We never like to see substantial convertible debt on a company’s books (> $500,000). We typically do not invest in companies with over $1,000,000 in convertible debt on the books.

What you should know about Series Seed:

  • The Series Seed Stock assumes the rights of the next preferred equity round, as if it was a convertible note, into the new preferred (typically) equity.
  • The Series Seed is a true equity round with limited protections and terms until a new round of preferred equity capital is raised. The risk is a qualified preferred round is never raised and the investor’s relationship with the company is governed by the limited protections.
  • Use them when you want equity vs. debt in a company.
  • There is no antidilution term typically, thus, they are only used for seed stage deals where a down round is unlikely.
  • There is typically no accrued or paid dividend term, as is common in a Series A financing.
  • Be careful to observe the terms of the Series Seed vehicle to ensure there is a liquidation preference and participation rights in future rounds of financing.
  • The vehicle does provide a Board seat for the stock class (typically).
  • There are at least four flavors of “series seed” documents. We use the Series Seed, not the TechStars, Y Combinator, or Founders Institute versions. Each has slightly different terms, some beneficial, and some not so.

What is this important:

  • Because the Series Seed vehicle is a true equity, you are shareholder and entitled to all the rights and privileges of shareholders including voting.
  • Because it is an equity, the class of stock can have special investor protections and privileges if you wish to add them.
  • Because of some of the inherent limitations, they are primarily used for lower valuation investments and small rounds of capital (e.g. a true seed round).
  • They should not be used as a bridge financing document.
  • The Series Seed essentially assumes the rights of the next preferred equity round of the company streamlining future rounds of capital.

General note about convertibles. Convertibles have their purpose, place, and time. We are seeing in the market that convertibles are only beneficial when the company raises “smart” money for its Series A Convertible Preferred round. “Dumb” money tends to overpay or create “clever” terms in deals that can cause many problems in future rounds of financing and lead to substantial dilution. So, make sure you work with your invested companies to find them the right follow-on investors to protect your investment. The Series Seed vehicle is a very good alternative to the traditional convertible note.

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