Chapter 10
Investment Rounds and Their Forms
Common Stock, Convertible Notes, or Preferred Stock?

To make sense of the different ways in which startup investments technically get from the investors' bank account into that of the company, it is helpful to understand the role that investment money plays in a new venture. Let's take a step back to remind ourselves of the process by which a new business grows.

Our story begins when the founders of a young company realize they need more money if they're going to grow their business. To raise this money, they decide to launch an investment round—a set of one or more investments made in a particular company, by one or more investors on essentially similar terms at essentially the same time.

An investment round can take many forms. So if the brother of the founder lends her $25,000 to get her company off the ground with the understanding that the loan will eventually convert into an ownership interest, that would be a round. And if a year or so later, a group of professional angel investors get together and each put in $50,000 to buy another piece of the company, that, too, would be a round. And if the company did really well, and after another year a large venture capital fund came along and invested $2 million for preferred stock, that would be a round as well.

In the parlance of the business, the first round would be a Friends and Family round, the second a Seed or Angel round, and the third a Series A round. The Series terminology comes from the way successive tranches of preferred stock are labeled, because each round has specific defined rights and priorities relative to the other rounds.

How do these investment rounds happen? In an ideal world, an entrepreneur bootstraps a startup, gets traction in the marketplace, and gets noticed; a smart investor calls the company and says “Hey, I think you're doing great things, I'd like to invest a million dollars in exchange for 10 percent of your common stock;” the entrepreneur agrees; the lawyers quickly draw up the documents; the investor sends over a check; and the deal is done. However, to say this is a rare occurrence would be to overstate wildly the likelihood of it happening.

What does usually happen? A company gets started, gets some traction, and then starts talking to as many investors as it can find, ideally being introduced to them by mutual acquaintances. This is known as starting a round.

In all cases, the fundamental requirement is that the company and the investor agree on how much is being invested, and on what terms. These items are included in what is known as a term sheet. (What the terms end up being, and how a company and the investor(s) arrive at that term sheet, are discussed at length in Chapter 12.) If the entrepreneur is lucky, at least one investor will make a funding offer by presenting a term sheet. If he offers the full amount the company thinks it needs, and the terms are acceptable (perhaps after some negotiation), then the paperwork is signed, the money wired, and the round is closed.

However, if both sides agree on the term sheet, but the investor is willing to put in some, but not all, of the money needed, the company then has a round in progress, with a lead investor having been identified. At this point, the company (assisted in some cases by the lead investor) goes to other investors with the term sheet from the lead to fill out the round and get the full amount. Other investors will be invited to put in money on the same terms as the lead investor (as part of the same round).

In some cases the term sheet will provide that the round will be closed (that is, stop taking in new investments and have the investors transfer in their money) by a certain date, regardless of whether any other investors join in. Typically, however, the term sheet will provide for a minimum amount to be committed before anyone, including the lead investor, actually transfers the money. It may also provide for a maximum amount, beyond which no additional investors will be allowed to join in.

In either case, since the terms of the round have already been negotiated and agreed upon by the company and the lead investor, the decision for all the following investors is a simpler, take-it-or-leave-it choice based on the signed term sheet.

The challenge for the entrepreneur is that getting a lead investor is the single toughest thing in the startup world because it means that someone needs to take the first step, similar to getting the first pickle out of a tightly packed pickle jar. And because it is so difficult to get that lead investor, companies are often desperate enough to try shortcuts.

One of those is to draw up a term sheet themselves, setting a valuation, terms, and target amount. They then try to function as their own lead investor by presenting their term sheet to potential investors, getting quickly to the take-it-or-leave-it decision, and skipping the tough step-up-and-lead decision.

This rarely works, because it is just about guaranteed that an entrepreneur negotiating that self-proposed term sheet with him- or herself will not end up with the same kind of term sheet that a smart, tough, lead investor would have negotiated. And because the pseudo-term sheet will be less investor-friendly than a real one, and because there is no investor providing validation, support, and a good chunk of the funding for the round, the resulting easy take-it-or-leave-it usually becomes an even easier “leave it.” In most cases, startups follow the traditional process for an investment round, with a lead investor providing the impetus.

Now let's examine the way various funding rounds operate, and start with some definitions:

A seed round means that, like planting a seed for the first time, this particular round is the first investment made into the company by someone other than the founder.

An equity seed round means that an entrepreneur sells a part of his or her business and therefore a proportional part of the good things (like profits) and the not-so-good things (like losses) to an investor.

In contrast to equity, debt means borrowed money that needs to be paid back. The entrepreneur rents the money for a specific period of time and promises to pay interest on the money for as long as the loan is outstanding.

Convertible debt means that the terms of the loan provide that the amount of money loaned may (or must, under certain conditions) be converted by the investor into shares of stock in the company at a particular price.

Angel rounds are traditionally the first money in a company after the founder's own money, and the founder's friends and family.

Series A rounds are usually the first professional outside money that is invested in exchange for ownership in a company, and typically are in the range of single-digit millions of dollars. Once the company has demonstrated potential for growth (usually evidenced by traction showing that people are willing to pay for whatever it has developed), it becomes attractive to fulltime, professional investors. These venture capital (VC) firms invest larger amounts of money (which had previously been invested in them by their limited partners—usually institutions, or very rich individuals).

If a company successfully uses the Series A money to grow and become more valuable, the original VC investors and/or new investors might be willing to invest even more money, usually at an even higher valuation. This next round is usually done as an issuance of Series B Preferred Stock, which, when the company is sold, gets paid out first, before the Series A (which in turn comes out before the angels' money). And if a company is growing quickly but needs increasing capital to fuel the growth, there might be additional rounds going through the alphabet. (One of my companies during the dot-com boom made it to Series F…but those were different times.)

Angel money typically enters the picture after the founder, friends, and family have invested in the company, but before venture capital firms get involved. The most fundamental division is between two ways one can put money into a startup: by purchasing part ownership in the company (equity) or by lending the company money (debt). Both equity and debt can be viable investment options. In the next few pages I will explain both, and the advantages and disadvantages of each.

How Equity Investments Work

When a corporation is established, its ownership is divided into equal pieces. These are called shares of common stock. That's what founders have, which is why it's also known as founders stock.

The company soon needs cash to fund its development and growth, so it turns to investors, such as angels, who purchase a part ownership of the company by paying cash for stock. But the stock we purchase is not the same common stock that the founders have—and that the employees have options on. Instead, the company creates and issues a different kind of stock called preferred stock.

While the name makes it seem to be all-around preferable to common stock, preferred is not inherently better, just different.

When the time comes to turn the value of the company into cash (during an exit), that cash may be more or less than the value that founders and investors agreed the company was worth at the time of the original investment. That is where the difference between the two types of stock is critical.

Preferred stock gets paid out first before any common stock gets paid—but it only gets back the amount that was paid for it (plus perhaps some dividends, which for this purpose act like interest). In contrast, common stock gets paid out only after all the preferred has been satisfied—but it gets its proportionate share of all the remaining value.

As an example, let's say that investors bought preferred stock for $200, and agreed that the value of all the common stock was $800. If the next day someone comes along and buys the company for $1,000, then it just confirms that everyone was correct in their assumptions, the investors get $200 and the common holders get $800.

But what happens if the company is sold for only $500? In that case, the preferred gets its $200 back first, after which the common splits up the rest—in this case $300—which is a lot less than the $800 value on which they raised their investment. On the other hand, what happens if the company is sold the next day for $2,000? The preferred stock investors still get their original $200 back, with the remaining $1,800 (including all of the newly created value) being divided among the common holders.

Based on this, you can see that it is much better to be a preferred shareholder in a down scenario, just as it is much better to be a common shareholder in an up scenario!

So, I hear you ask, if investors are putting money into a company precisely because they believe its value will increase dramatically, why would they want to buy preferred stock as I just described it?

The answer is, they don't.

What investors in startups buy is actually a hybrid type of stock, called convertible preferred stock.

The primary feature of convertible preferred stock is that, in an “up” scenario, it converts into common stock, and everyone is happy.

However, if the “down” scenario happens, then it works differently: the first money that comes in goes to pay off the cash that the investors paid (in the example above, the $200). Anything left over (in this case it would be $300) goes to the holders of common stock. The effect of this is to adjust retroactively the nominal value assigned to the founders' contribution.

That is why there are different classes of ownership in startup companies. At a basic level, the purpose of different classes is to ensure an appropriate match between risk and reward for founders and investors coming in at different times under different sets of conditions. Buying convertible preferred stock gives investors the best of both worlds and is rather like having your cake and eating it, too.

It starts as preferred stock, so if the company falls on hard times and is sold for less than it was originally valued at, we get the full amount of our investment back. But, if good things happen (as everyone hopes), then immediately before the sale of the company we get to wave a magic wand, and our preferred shares convert, one-for-one, into common shares, so that we can participate in the increased value along with the other common stock holders.

Investors can also benefit in other ways. Because the common and convertible preferred are separate types of shares, the company's charter and other documents can (and usually will) be amended to give different rights and privileges to the different types of stock.

The Discounted Convertible Note

So far, I have been focusing on the complexities of equity investing, but there's another way you can invest in a startup, and that's by lending money to the company for it to use in financing its growth.

The key difference is that debt results in a fixed payback regardless of whether good or bad things happen, while equity results in a variable payback from $0 (if the company goes under) to potentially billions of dollars (if the company ends up being worth a lot of money).

Debt has its advantages to a lender—primarily, the certainty of return. The borrower owes the money (plus interest) due on a specific date regardless of whether the company succeeds or fails. But startup investors aren't interested in ordinary debt with its attendant low returns. Instead, they always want to own an equity share of the company (and therefore its upside potential) rather than owning debt (which, no matter how successful the company gets, will only pay back the face amount of the loan, plus a relatively small interest payment).

There is one problem with this from the perspective of the startup founder. It happens that, for regulatory and other reasons, the legal costs of documenting an equity round can be high, often in the many tens of thousands of dollars. This is not a problem if a big venture fund is investing millions of dollars, but it can be problematic in the context of a small angel round of tens or hundreds of thousands of dollars.

To avoid the cost and complexity of documenting an equity round while still providing investors with the enticement of being able to participate in the upside of equity ownership, it is not uncommon these days for startup funding to take place with a hybrid investment vehicle known as a convertible note.

A convertible note carries with it the guarantee that, at some point in the future, the angel will be able to convert what started out as a loan into the equivalent of cash, and use that money to buy stock in the company. This can be useful, quick, and less expensive for the investor and the company, but it creates complications. Here's why.

If I'm putting $100,000 into Company A in the form of debt, the only thing we need to discuss is the interest rate that Company A will pay me for using my money until they pay it back. On the other hand, if I'm investing in the form of equity, then we need to decide what percentage of the company's ownership I will end up with in exchange for my investment. To figure that out, we use the following math equation:

Since we can calculate any one of the three terms if we know the remaining two, and we already know how much I'm investing ($100,000), in order to figure out what my ownership percentage will be after the investment, Company A and I need to agree on what the company valuation is (or will be) at the time I purchase my shares of stock. We have already covered valuation methods in Chapter 9, and based on these, the company and I would negotiate a valuation figure we are both willing to live with. I'd give them the money today, they'd give me the appropriate percentage of the company's stock, and we'd be all set.

But that's not what I'm doing when I invest in a convertible note. Instead, I'm lending Company A the money today with the understanding that I will be able to convert that money into its equivalent in stock someday.

But because that conversion is going to be happening at some point in the future, while I'm giving the company the money today, we need to figure out a few things today, before I am willing to give them the money. Specifically, we need to decide (a) when in the future the debt will convert to equity, and (b) how we will determine the valuation of the company at that point in the future.

The answer to both turns out to be the same: we will wait until a richer, more experienced investor agrees to buy equity in the company. At that point we will convert the debt into equity (which answers question a) and use as the valuation whatever that other investor is using (which answers question b).

So far, so good. But we're not quite done. The fact is that I was willing to invest in Company A at a time when that other investor was not, and the founders used my investment to make the company more valuable (and therefore got a high valuation from the other investor). It doesn't seem fair that I should bear the early-stage risk, yet get the same reward as a later-stage investor.

We solve this problem by agreeing that I will get a discount to whatever the other investor sets the valuation at, which is why we call this a discounted convertible note. The discount is typically set at anywhere from 10 to 30 percent of the next-round pricing.

Although that sounds fair, it really isn't (or at least serious investors don't think it is). That's because the more successful Company A is at using my original money to increase its value, the higher the valuation the next guy will have to pay, and pretty soon the little discount I'm getting doesn't seem so fair after all. For instance, if that same investor would have valued Company A in its early days at $1 million, but is willing to invest in the now-much-more-successful company at a valuation of $5 million, that means the company founders were able to increase the company's value by 500 percent using my original seed money.

If my convertible note says that it will convert at a 20 percent discount to that $5 million, for example (which, if you do the math, is $4 million), I would seem to have made a very bad deal. Why? Because I end up paying for Company A's stock based on a $4 million valuation, instead of the $1 million it was worth in its early days when I was willing to make my risky investment.

We solve this problem by saying, “Okay, because I'm investing early, I'll get the 20 percent discount on whatever valuation the next guy gives you. But just to be sure that things don't get out of hand, we will also say that, regardless of whatever valuation the next investor is willing to give you, in no case will the valuation at which my debt converts ever be higher than $1 million.” That figure is known as the cap, because it establishes the highest price at which my debt can ever convert to equity. And that's why we call this form of debt investment a discounted convertible note with a cap.

Over the past 20 years, the typical structure for seed/angel deals has shifted from common stock (in the mid-1990s), to convertible notes (late 1990s through early 2000s), to full Series A convertible preferred (mid 2000s), to convertible notes with a cap (late 2000s), to series seed convertible preferred or similar (present). This shows the increasing sophistication of investors and entrepreneurs, the increasing experience and publicity surrounding the advantages/disadvantages of various options, and the increasing availability of model documents and online term sheet generators for different choices.

Recently, Y Combinator, the leading accelerator program, unveiled a new type of equity called a SAFE, which stands for Simple Agreement for Future Equity. SAFEs have some of the good features of convertible notes, but because they are not actually a form of debt, they avoid some of the problems. Y Combinator has open-sourced the documents and published them at http://ycombinator.com/safe/. It remains to be seen if the industry will adopt these, and if so, for what types of transactions. My guess is that they make the most sense for very early investments, at low dollar amounts in pure startup companies, particularly in cases where seed investors are willing to wait for an expected future round for their protection. SAFEs are likely to find use in some hot deals where investors just want to be in the deal, but will probably not be adopted by angel groups or financially focused angels who are proactively leading an investment round.

Fine Points of Investing in Discounted Convertible Notes

Another factor bearing on the advisability of doing a convertible note is that it is debt, not equity, which is both good and bad for the investor. It's good because in a down liquidation scenario the note gets paid out ahead of anything going to the founder or any other equity holder; it's bad because, in an up-liquidation scenario prior to conversion, unless the note is carefully drafted, the company can just pay it off with interest, and avoid giving the investor any upside.

Notes typically provide fewer rights and protections for investors—those important details contribute to the cost of writing and negotiating an equity round. One further wrinkle is that while everyone investing in an equity round will be investing on the same terms at the same valuation, with a series of convertible notes a company can choose to raise money at different valuations from different investors.

The primary potential problem from an investor's point of view with using convertible notes (whether capped or not) for seed deals is not that the later Series A investors take advantage of the seed investors by making them second-class citizens. Rather, it is that the Series A investors don't want the seed investors to take advantage of the Series A. This can happen in one of two cases: either (a) the seed angels are greedy, and the negotiated discount to the Series A valuation is too large for the Series A's comfort, or (b) the convertible note has a valuation cap that becomes untenable in the unusual case of an enormous increase in valuation between the two rounds so that the seed investors are getting a much better financial deal than the Series A's, but end up with all the same rights.

Even in those cases, however, negotiated adjustments to the seed deal are more likely to be purely financial than anything else. Otherwise, and assuming that the total of the convertible notes is relatively small compared to the new money of the Series A (say, $400K of seed- convertible notes converting as part of a $2–$3 million Series A), professional venture investors are generally comfortable with the discount and welcome the seed investors' participation.

Because they are technically loans, all convertible notes have a maturity date on which the principal and any accrued interest must be repaid to the lender. But because convertible notes are designed to give investors an equity interest in a company that will eventually be worth much more than their investment, the intention is always to convert into equity. After all, if you were just after the interest on a loan, you could find less risky things to invest in than a startup.

Therefore, the only reason that an investor would not convert into the next round of equity would be if the company were doing so poorly that there was no such round. (Think about it this way: assuming a convertible note with a valuation cap, which is what all smart investors would do, it would always be to the investor's advantage to convert, regardless of whether the valuation of the round was high or low.)

The flip side is that if the company is doing so poorly that it can't raise another financing round, it is highly unlikely that it will have the cash on hand to repay the debt at maturity, so there would be no purpose served by the investor demanding repayment…you can't get back what doesn't exist.

Therefore, if the repayment-at-maturity clause is not used to get the investor's money back, what is it used for? In practice, it is used as an incentive (carrot/stick) for the investor and the company to sit down for a heart-to-heart talk, to figure out what to do next…with the balance of power this time in the hands of the investor, because the company was not able to deliver on its projections. As a result:

• If things are generally going well, the investor(s) will usually extend the note to give the company more breathing room, maintaining the status quo.
• If things are not going so well, and it doesn't look like there will be a follow-on financing round any time soon, the investor and company might agree to convert the note into equity at a lower than anticipated valuation (if there had been a previous round) or at whatever valuation they agree on.
• In a worst case, if the company is in really bad shape, the investor can dictate whatever terms she or he wants, using the implied threat of forcing the company into bankruptcy because it can't repay the debt. This is particularly the case if the note is secured by the company's assets.

While that last option sounds horrendous, in practice I have seen it used mostly for good. There are many permutations of what “good” looks like, but, essentially, holding a past-due note from a company that can't repay it is like holding a nuclear weapon: using it probably destroys all value for everyone, but having the ability to use it, as in the geopolitical theory of Mutually Assured Destruction, means that everyone is at least forced back to the table to negotiate a way of saving the company.

You hope the repayment-at-maturity clause will never have to be used in this way—but if the time comes when it is necessary, an investor will probably be glad it's there.