A popular option in seed round financing is a convertible note instead of setting a valuation in an equity financing. A convertible note is basically a loan where the investors convert the debt into equity in the next round of financing at a step up. A common step up is 20%, which means for every dollar the investors lend, they get $1.20 worth of shares in the subsequent round.
The appeal of convertible notes is 1) it defers the negotiation about valuation to the next round 2) it is often much cheaper in terms of legal fees (~$5k versus $20-40K).
Here’s why a lot of seed investors don’t like convertible notes:
1) Most importantly, they split the entrepreneur’s and investors’ incentives – for the subsequent round, the entrepreneur benefits from a higher valuation, the investor from a low one. Most investors work hard despite this to help the company, but nevertheless the note creates friction between people who should be working in tandem.
2) On more than a few occasions VCs in subsequent rounds have said “I don’t want to give the seed investors a 20% step up.” Sure, the step up is in a contract, but the investor in the subsequent round can always make their investment contingent upon modifying that contract. In the end, it ends up pitting seed investors who wants their step up versus entrepreneur who wants to get the financing done, and the seed investor is forced to choose between getting the step up they deserve and being “the bad guy” who spoils the financing.
One increasingly popular compromise is to do a “convertible with a cap.” What this mean is that you set a cap of $N million dollars valuation and a step up of M%, and on the subsequent round the seed investor gets the better of the two. If the cap is low enough, this mostly rectifies #1 above since the investor has the economic incentive to increase the valuation above the cap. It doesn’t rectify #2, however, but does have the benefit of being significantly cheaper in terms of legal fees than a proper equity financing. There is nothing worse than spending 5%-10% of your seed round on lawyers.