Corporate Finance & Securities

Seed financings: comparing convertible debt, KISS and SAFE docs, and priced equity

Convertible debt is a type of bridge loanToday we’re looking at the different types of documents frequently used to raise seed rounds. (A seed round is the initial capital raised from outside investors.) We’ll discuss the least complicated option first and move down the list in order of complexity. Once we’ve gone through equity, convertible debt, and convertible equity (like SAFE and KISS agreements), we’ll cover the pros and cons of the different approaches.

Priced Equity Round

The basics of the agreement in one sentence: The company agrees to sell a set portion of the company for a set price.

Example: Company offers investor a 10% interest in the company for $500,000.

Example docsSeries Seed docs

Nuances: Usually the investors get preferred shares that have rights in addition to those of common stock. There are a number of terms that could be negotiated with regard to what rights preferred shareholders receive. There is an increasing consensus on what terms are “standard,” and therefore there often isn’t too much negotiation on what rights preferred shareholders receive in the context of a seed round.

Convertible Debt

The basics of the agreement in one sentence: The company agrees to borrow money at a set interest rate with a set maturity date, and the principal and interest will convert into shares of company stock if and when the company raises financing by selling shares of its stock in a priced equity round. The priced equity round is generally defined as a “qualified financing,” which includes a threshold for the amount that the company must raise to trigger the conversion.

Example: Company offers investor a $500,000 note with 5% interest and repayment in 18 months, and the interest and principal will convert into preferred shares issued when the company raises at least $1,000,000 in a stock offering.

Example docsTech Stars convertible note

Nuances: Often times the note has a capped price for conversion in the form of a valuation cap. This is good for investors because the higher the price, the fewer the number of shares the investor will receive upon conversion. Notes also often have discounts, which say that the price per share for conversion will be lower than, or discounted from, the price per share series A investors pay for their shares. The effects of conversion often hide some of the economic impact on the company.

SAFE

The basics of the agreement: The company agrees to raise a set amount of money from an investor in exchange for a to-be-determined amount of the company that is based on the next financing round.

Example: Company offers to accept $500,000 from an investor in exchange for a promise to issue $500,000 worth of shares that are based on the purchase price of shares in the company’s next financing round.

Example docsSAFE Agreement

Nuances: As with the convertible note, there may be a valuation cap, a discount, or both. The SAFE does a good job of minimizing some of the unintended side effects of convertible debt—it has a mechanism that keeps SAFE holders from getting multiple liquidation preferences and full ratchets (here’s our post that dives into how convertible holders get multiple liquidation preferences and full ratchets and why founders should care).

KISS

The basics of the agreement: The company agrees to raise a set amount of money from an investor in exchange for a to-be-determined amount of the company that is based on the next financing round, and there may or may not be an interest rate and a maturity date attached to the KISS agreement.

Example: Depending on the variety of KISS it could be an example like the one above for convertible debt or like the one above for SAFEs.

Example docsKISS Agreements

Nuances: As with the convertible note and the SAFE agreement, there may be a cap, a discount, or both. And as with the SAFE agreement, the KISS does a good job minimizing unintended consequences of convertible debt. The KISS also has some more investor-friendly terms like information rights for KISS holders that are typically only given to shareholders.

So, which option is best?

Well, if you’re a founder, I think you’re best off with a priced equity round. If you’re an investor it’s not quite as obvious of an answer, but I still think you can make a compelling case that a priced equity round is best, as it is in the best interest of the company and ultimately the investor wants the company to succeed.

That said, if you’re a founder and you need money, and the only investors you can line up are investors that insist on convertible notes, then convertible notes are your best option.

There are three main problems with convertible debt. The SAFE docs solve two of them. The KISS docs solve one or two of them.

With unpriced round neither side knows what they’re getting.

Convertible debt was created as a solution for companies that are “too early to value.” If a company is just getting going, it can be tough to justify the $5,000,000 valuation implied by the 10% for $500k priced equity deal. Convertible debt lets everyone kick the valuation can down the road. But then nobody knows what they’re getting. If there’s a valuation cap, the investor will know the minimum % of the company that they would acquire on conversion, but the founders won’t know how much they could be giving up. If the next round has a low valuation, the convertible debt investor might get, for example, 30% of the company—substantially diluting the founders. In practice the valuation cap functions like a valuation. Companies will generally be better off issuing a priced round at the capped valuation, if they can get the investor to agree.

The maturity date on convertible debt poses an existential threat to a company.

If a company can’t raise money prior to the convertible debt maturing, investors can call the debt due, and the company will be insolvent/bankrupt. This could be the end of the company. With this pressure, founders might not negotiate as good of a deal with its series A investors, since they have to get a deal done to keep the company going. And if they don’t raise money in time, the convertible note holders will have substantial leverage to renegotiate terms, and the company will have a difficult time raising new money from investors with this outstanding debt—they probably won’t want to give the company a million dollars just to watch the company turn around and hand the million dollars to earlier investors.

The SAFE solves this issue by not having a maturity date. The version of the KISS docs that doesn’t include a maturity date also solves this issue.

The economic side effects of convertible debt are harsh on other shareholders.

As noted above and in this post, holders of convertible debt receive, by default, terms that shareholders don’t normally receive. Both the SAFE agreements and the KISS agreements solve these issues.

Summary

Priced equity Convertible note SAFE KISS
Existential threat
from maturity date
No Yes No Maybe
Multiple liquidation
preference
No Yes No No
Full ratchet No Yes No No
Silly acronym No No Yes Yes
Information rights
for investors
No No No Yes
Parties know
what they’re getting
Yes No No No
Parties have to
value company
Yes No No No

 

        


Kyle Hulten

When I'm not in the office I enjoy sunny afternoons with friends on the deck at Ray’s Cafe.


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