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By: Kristine Di Bacco and Doug Sharp Fenwick & West LLP
Start-up companies use seed financings primarily to raise the capital required to build a minimum viable product and test their product-market fit. This article provides guidance to company counsel and founders on how to identify a seed investor and choose the financing method that best fits the company’s needs. The article assumes that the company is a Delaware C corporation, which is the market standard for venture-backed companies.
A typical seed financing features a founding team (and perhaps up to a handful of employees) raising between $500,000 and $2 million to allow for 12 to 24 months of operational capital. During this time, the founders will attempt to prove out their idea and develop the traction required for raising the next round of financing (known as a Series A financing) from a professional venture capitalist.
A seed investor’s purpose is typically to test an investment hypothesis (either on a founding team, idea, or market) by providing capital to a company that will test the hypothesis. Investors at this stage will often make a large number of small investments in a variety of companies on the theory that, while many of them will fail, the few that are successful will generate significant returns for the investor. At the seed stage, investors are deciding to make their investment primarily on their assessment of the quality of the founding team and the market opportunity presented by the business model.
A few traits of founders that are seen as positive signals to investors include, but are not limited to:
To decide whether to invest in a seed round, an investor will likely meet with the founding team, who will give the investor a pitch on their product/idea, market, team, and business model. Often the company’s existing contacts (e.g., advisors, former co-workers, or lawyers) set up these pitch meetings (known as a warm introduction).
Types of Investors
There are a variety of typical investors in such financings:
Most rounds of seed financing consist of a blend of the above investors, as each brings its own value to the table (beyond just capital). One balancing act to consider is whether to include a professional VC in the seed round. While it can be seen as a positive signal initially, it can be a double-edged sword in that the VC’s decision to either lead, participate in, or elect not to participate in the subsequent preferred stock financing will be a very strong signal in the market (and often the VC will elect not to participate or lead the round, which reduces potential new investors’ confidence).
The three most common types of series seed financing instruments are convertible notes, simple agreements for future equity, and preferred stock. These three instruments cover virtually all seed financing transactions in Silicon Valley and with start-ups across the country. The company almost always determines which instrument to use, unless there is a significant (lead) investor that negotiates the terms of the entire financing round on behalf of all other investors and feels strongly about the form the seed financing takes.
You should note that sales of common stock are not typically used for seed financing for two primary reasons. First, common stock does not come with the various investor-friendly terms (described below) that other instruments include, so it is less appealing to investors. Second, it places a price on the outstanding common stock, which then will set the price for grants of options and restricted stock to employees. Typically, a valuation firm using 409A methodology (i.e., performing a valuation before a liquidity event such as an initial public offering in accordance with Section 409A of the Internal Revenue Code) will value common stock in an early stage start-up at around 20-25% of the preferred stock. Thus, a priced common round with investors would eliminate this lower price benefit, which is one of the key recruiting tools for early employees.
Convertible notes are loans (i.e., debt) by an investor that convert into an equity interest in the company upon a priced preferred stock financing meeting certain conditions. Convertible notes are by far the most common instrument used to complete seed rounds.
In drafting convertible notes, you should include the following key terms:
The advantages of convertible notes include:
The disadvantages of convertible notes include:
Convertible notes are the default method for raising seed capital (and definitely for seed rounds raising less than $2 million). In terms of process, convertible note financings may or may not begin with a formal term sheet. Because the terms are relatively straightforward, it is often customary for you, the company counsel, to simply draft the convertible note documentation based on rough parameters agreed to by the company and its initial lead seed investor. Often there is little to no negotiation outside the key terms listed above, as they are legally straightforward to implement (which is another benefit of using a convertible note structure).
Simple Agreements for Future Equity
In December 2013, Y Combinator (a leading start-up accelerator) introduced its alternative to convertible notes—Simple Agreement for Future Equity (SAFE), https://www.ycombinator.com/documents/#safe. It provides four types of SAFEs, each of which is freely accessible on the Y Combinator’s website:
In drafting SAFEs, you should be familiar with the following key terms:
Note that SAFEs include neither an interest component nor an obligation to repay absent a conversion.
The advantages of SAFEs include:
The disadvantages of SAFEs include:
SAFEs are becoming more and more common as the market becomes more accustomed to them. Since they have very few inputs and, if used as provided by Y Combinator, require few changes to the provisions, founders tend to use them without consulting outside legal counsel first, who will often explain the above issues and either tweak the documents to resolve them or guide the company to use a more traditional convertible note structure. In general, closing a seed financing with SAFEs is straightforward once the company and investors agree to the key terms.
There are two types of preferred stock documents used in seed financings: the lightweight version www.seriesseed.com and a full Series Seed set of documents.
Full Series A Documentation
Some professional VCs have interpreted Series Seed to mean full-blown Series A documentation (with all the related rights and privileges) as per the National Venture Capital Association’s model legal documentation, http://nvca.org/ resources/model-legal-documents/. This includes five major transaction documents:
There are also additional ancillary documents like a legal opinion and closing certificates.
The full Series A documentation is typically significantly more expensive in legal fees and requires the negotiation of all the terms and documents that will be used in a later Series A financing. This can be difficult since the seed round often does not include traditional lead investors with which the company can negotiate the documents. This structure of transaction can typically take 4-6 weeks to complete (from finalization of the term sheet to closing of the investment).
Series Seed Preferred Documentation
There is also a set of Series Seed preferred stock documents (http://www.seriesseed.com/) that take into account various perspectives from the broader Silicon Valley community, including VCs and entrepreneurs. These documents greatly simplify the transaction and defer the detailed negotiation of a fulsome set of investor rights until the Series A financing.
The Seriesseed.com approach includes most of the key terms included in a traditional full Series A round, including:
On the other hand, it does not include:
The investors will receive the same rights as the future investors in the Series A financing. Importantly, the Seriesseed.com approach only requires two documents:
No ancillary documents like a legal opinion and closing certificate are required, so the process is significantly streamlined and therefore less expensive. Using the Seriesseed.com documents is straightforward. All the key terms are defined in a definitions section in the beginning of the investment agreement and the certificate of incorporation.
Regardless of how the seed investment is structured, it’s critical that the company has a valid federal securities law exemption from registration under the Securities Act of 1933, as amended (Securities Act), for the issuances. The two most commonly used federal exemptions for seed financings are:
Historically, the private placement exemption was the traditional exemption relied upon for federal securities exemptions, but Regulation D has now become more common and most companies rely on this exemption because its parameters are more certain than Section 4(a)(2) alone. Rule 506(b) allows for the company to sell securities to an unlimited number of accredited investors (defined in Rule 501(a)) (17 C.F.R. § 230.501) and up to 35 other purchasers. If those other purchasers are unaccredited, they must be sophisticated (i.e., have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment). However, it’s generally advisable for companies using this exemption to sell only to accredited investors. This is because including nonaccredited investors requires a company to deliver exhaustive disclosure and offering documents, which can be prohibitively expensive and time-consuming from a legal and accounting perspective for a young company to prepare. It’s also worth noting that if you want to take advantage of the new provisions in Rule 506(c) that allow general solicitation, all investors must be accredited.
A company that makes an offering under Regulation D is required to file a Form D with the Securities and Exchange Commission (SEC) within 15 days of the first sale of securities. Once filed, the Form D is available to the public on the SEC website, and various news organizations will trawl the SEC website and report on start-ups’ fundraising activities. Thus, you should advise the company to prepare a press release on a parallel path to the Form D filing in order to manage its public narrative.
company also needs to comply with state securities laws (blue sky laws) in the state in which it is located and the states in which each of its investors is located. Compliance regimes vary from state to state, but most often there is either a notice filing if using Section 4(a)(2) or an electronic filing if using Regulation D. For example, if the company relies on the 4(a)(2) private placement exemption in California (and does not file a Form D), it should file a 25102(f) notice (http:// www.dbo.ca.gov/forms/doc/DBO-25102f_Packet.pdf) with the California Department of Business Oversight. Some states require the filing to be made in advance of the sale of securities, so you should be careful to check the blue sky regime in each applicable state before the securities are sold.
Kristine Di Bacco represents emerging technology companies primarily in the consumer internet, e-commerce, FinTech, digital health, and consumer hardware and software sectors at Fenwick & West. Her practice includes a broad range of corporate transactional matters, including the formation of new start-up companies, venture capital financings, mergers & acquisitions, and public offerings. Kristine provides clients with practical and thoughtful advice to help solve their business and legal issues and assists clients in structuring, negotiating, and closing business transactions quickly and effectively. Kristine also represents and advises leading incubators, angel investors, and venture capitalists investing in technology companies. Doug Sharp focuses his practice at Fenwick & West on a variety of corporate matters to support clients in the technology industry. While attending law school, Doug was the Financial Director & Member Editor for the Stanford Technology Law Review.
To find this article in Lexis Practice Advisor, follow this research path:
RESEARCH PATH: Capital Markets & Corporate Governance > Industry Practice Guides > Technology > Practice Notes
For a detailed examination of venture capitalists and private equity firms, see
> PRIVATE EQUITY INDUSTRY PRACTICE GUIDE
RESEARCH PATH: Capital Markets & Corporate Governance > Industry Practice Guides > Private Equity > Practice Notes
For additional information on convertible notes, see
> UNDERSTANDING CONVERTIBLE DEBT SECURITIES
RESEARCH PATH: Capital Markets & Corporate Governance > Debt Securities Offerings > Rule 144A/ Regulation S Debt Offerings > Practice Notes
For an explanation on the use of Simple Agreement for Future Equity (SAFEs) securities in the crowdfunding context, see
> MARKET TRENDS: CROWDFUNDING – OTHER KEY MARKET TRENDS
RESEARCH PATH: Capital Markets & Corporate Governance > Market Trends > Equity > Practice Notes
For an overview on convertible notes, see
> UNDERSTANDING ANTI-DILUTION ADJUSTMENT FORMULAS IN CONVERTIBLE BONDS
For guidance on managing a private offering, see
> MANAGING THE PRIVATE OFFERING
RESEARCH PATH: Capital Markets & Corporate Governance > Private Offerings > Private Placements > Practice Notes
For a sample convertible note to be used in connection with a pre-seed or seed financing transaction for a start-up company, see
> CONVERTIBLE PROMISSORY NOTE
RESEARCH PATH: Corporate Counsel > Financing and Venture Capital > Venture Capital Financing > Forms