Setting the Terms with First Round Investors

By: Adam Salomone

Participating in a panel discussion recently, an entrepreneur asked about the various mechanics of raising a first round of funding from investors. The most common question that comes up is whether to raise on a note vs equity. And, in the case of convertible notes, how to incorporate valuation caps and discounts to appropriately incentivize early investors. 

  • Note or Equity? In most cases, entrepreneurs have two vehicles for raising money from traditional investors. The first is a convertible note, the second is a priced equity round. In general, any "friends and family" and pre-seed/seed rounds are typically raised on a convertible note. As opposed to a priced equity round, a convertible note round allows an entrepreneur to raise money without immediately giving away equity, while also forestalling putting an exact valuation on the company. This is particularly helpful when a company is pre-revenue, and there's no reliable way to value the company's assets. A convertible note is exactly what it sounds like: it's a promissory note that converts to equity at a later round. Typically, there will be specific language in the note that requires the entrepreneur to raise a set minimum on their round, as well as language that determines when/how the note will convert to equity. Keep in mind you may encounter some investors who don't invest in convertible note rounds, in part because they want equity for their investment upfront. You have to weigh whether those investors are aligned with your goals for the business.
  • Caps or Discounts (or Both)? Assuming you're raising money on a convertible note, you'll want to consider either a valuation cap, a discount on the next round of funding, or both. When we invest in early-stage companies, we consider uncapped or undiscounted notes to be a huge issue, as there's no incentive for investors to come in early and assume the risk of financing the startup at such an early stage. We'll tackle caps and discounts separately:
    • Valuation Cap - When you structure your convertible note, you have the option to put a valuation cap on the note. How does this work? In this example, let's say you set a valuation cap of $5MM on your note. When you prepare to raise your next round of funding (presumably it will be a priced round), all of the investors in the convertible note will convert at $5MM, regardless of whether the valuation is higher. So, if you raise money at a $10MM valuation for your first equity round, your convertible note investors convert at $5MM (or a 50% discount on the raise). The only instance where valuation caps don't apply is if you raise your first round below the cap. In that instance, your convertible note investors will convert at exactly the same valuation as your equity round investors (unless you also have a discount on the note, see below).
    • Discount - It's common on a convertible note to see 20-25% discounts. The discount you set dictates how much of a rebate early investors get on your first equity round. Let's say you have a 20% discount on your note and you raise your first priced round at $10MM. Your convertible note investors would convert their investment at an $8MM valuation (20% discount off of $10MM).
    • Entrepreneurs can choose one or the other of these methods, or both in conjunction to incentive early investors to come into the round. 
  • Right Fit? While it doesn't relate to deal terms specifically, it's impossible to overstate the importance of having the right fit with your investors. Oftentimes, relationship issues come up at the negotiating table, as you get a unique view into what's important for investors and what they are looking for. In general, you want to ensure that you are aligned with your investor, they understand your vision for the company as well as the timeline and strategy. And, it also works in the opposite direction: smart investors want to work with entrepreneurs who want to work with them. Be someone who people want to work with and investors will take notice. 

As a last word on convertible notes: while it's common for many entrepreneurs to generate their own paperwork, we're beginning to find more founders using Y-Combinator's SAFE documents (Simple Agreement for Future Equity). While generating convertible note paperwork can cost anywhere from $10-25K with a good lawyer, SAFE documents are very straightforward and cut out many of the elements that cause friction in a deal. Some investors are less comfortable with them, but they are becoming more common and provide an easier path to getting the deal done.