In response to my previous post on how we raised angel funding, I received quite a few enthusiastic emails asking for my opinion on matters related to raising the angel round I wrote about. The most common question, unsurprisingly, was on setting the valuation of the seed round, when so many things were still unknowns – what market the company will compete in, or what product it will eventually go on to build.
Use Convertible Debt
The question of seed round valuation is perfectly fair, and one I found myself contemplating as I drove home from work, on the Capital Beltway in Washington, DC., sometime in March, 2009. On one of my Skype calls with Sharat, I asked him what he thought about this.
“Dude, we don’t set a valuation, ” Sharat responded even as I barely got the words out of my mouth.
“What do you mean we don’t set a valuation? How will we decide how much equity to give them?” I countered.
“We’ll use a convertible note to raise this seed round, and defer the valuation-setting song and dance to the next round of financing, which should be in about a year. All we need to do is ensure that the investors in this round are adequately compensated for the risk of investing in us this early.” Sharat told me in his pedantic voice, which he rarely used except when I asked him questions related to finance.
“Ummm, ok … and how exactly do we do that?”
“We’ll raise the money as debt that compulsorily flips into equity when the next round happens. At that point, we give the seed investors (the angels we’re raising money from now) a discount on the valuation, because they invested in us when the uncertainty was much higher.” Sharat went on, evidently quite at ease with how this all actually works.
“Woah, slow down, this is all going over my head. What is this discount thing you’re talking about?”
Even though I am the technologist and Sharat the banker, I thought it was important for me to understand how this really works. For that matter, I think every entrepreneur ought to understand the mechanics of deal financing, because the details are important and knowing them in your head is crucial to being able to effectively negotiate financing rounds.
“Okay, lemme explain with an example,” Sharat continued, being patient as always. “Let’s say we raise $50k as a convertible note from angels in our seed round. We take the money as a loan, basically, promising them that the loan converts into equity under certain conditions. You with me so far?”
“Yeah, go on.”
“Now when we raise our next round (Series A), let’s say we raise $500k from a VC firm at a pre-money valuation of $1 million. Since the seed round helped us increase the company’s value to that much, we ought to give the angels a valuation that is lower than this $1 million, because at the point they invested, there was a lot less. Just you and me and a prototype, basically. Right?”
“Right. So you’re saying that that is the point at which we say, Ok angel, you get a discount on the $1 million valuation so to determine how much equity your money buys, we say the valuation for the seed round is $750k (equivalent to a 25% discount)”
“Exactly. $750k or $600k or whatever. That is the discount that all seed round investors get, which is fair given that the amount of risk they took on was greater than the VC firm is taking on a whole year later.”
And that my fellow entrepreneurs is basically how a convertible note works.
At MobStac, we used a convertible note (in India, this is often called a convertible debenture) to raise our seed round back in June 2009. Our logic for using a convertible note was quite simple: neither the angels nor us entrepreneurs have a clue what the company really is worth so why make it their word against ours or vice versa? And what if we get it completely wrong and the next round is actually a down round? I hardly think there’s anything more depressing for everyone than a round in which the valuation of the company actually goes down, especially in the seed stage. Angels are unhappy because their investment is worth less, not more. And entrepreneurs are unhappy because no one likes to see the value of their company go down – it’s a hard pill to swallow. So a convertible note just seemed to be the proper (not to mention uncomplicated) route to take.
Increasingly, quite a few startups in India are considering taking this route, and I think even more startups should. If you raise money on AngelList or from anywhere in the Valley, you’ll find that convertible notes are the lingua franca of seed stage investing. Why should seed investing in India be any different?
The Venture Hacks guys have a bunch of articles on the topic, if you’d like to do some more reading to understand the nuances of convertible notes. There are also other good posts by Brad Feld and Paul Graham.
MobStac’s 2009 Convertible Note: Open-sourced
To kickstart our enthusiastic support of this method, we’re open-sourcing the convertible note that we used in 2009 as a template that anyone can use for their own seed rounds:
A couple of notes about the template:
- All variables are highlighted and for you to fill out based on your situation. For e.g., the maximum size of the round, the interest rate on the note, etc.
- The cap on the discount is set to 25% as an example – you can make it whatever you and your investors agree to.
- In the event there is no follow-on round of financing within the stipulated time, the valuation is decided based on mutual consent, subject to a minimum value.
- Of course, you’re free to modify any clauses and add others that may be relevant to your situation.
I hope this helps some of you out there get your seed round closed faster so that you can move on to building the product!
As always, I would love to hear what you think. I’m also happy to answer questions that you may have so feel free to leave me a comment or shoot me an email.
(May 24: Updated to reflect Pranay Gupta’s comment – thanks!)
Disclaimer: This post and its associated document does not constitute (and is no substitute for) legal advice. I write to share my experiences with the entrepreneur community, but am in no way responsible for any legal consequences that may arise from applying this information. My recommendation is to consult a lawyer for advice during fundraising.
