What’s the best Seed Financing Structure? A primer on Series Seed vs Convertible Notes and SAFEs

We’ll make this really simple if you want to save some time. Raise your seed capital via a Series Seed financing tied to the NVCA terms.

Not convinced and like reading blog posts? Then read on…..

There has been a significant amount of debate about the use of convertible notes, SAFEs and a variety of fancy new structures dreamed up by people in the past few years as a structure for seed financing rounds (or pre-seed, or ‘day zero’). With the exception of convertible notes, which have been around forever, these new structures are being pushed instead of the “traditional” method of structuring the seed round as a Series Seed financing. We’re starting to see advocates for each approach move away from the structural arguments and completely ignore the fact there are pros and cons to each of these structures, and instead have an almost religious fervor that one structure is evil or the other is short-sighted. There seem to be a load of early investors scrambling to prove their “entrepreneur friendly” credentials and so now the discussion around this topic borders on the absurd.

[Quick side note: Investors are “Entrepreneur Friendly” when they work with the founders, bring significant value to the table and understand their proper role. This is what founders should be seeking when they select early-stage investors. Selecting people because they are publicly vocal that convertible notes/SAFEs/anything are the best structure or because they espouse terms that are very favorable to founders even when most of their own investments don’t contain these terms is not “Entrepreneur Friendly”, it is self-promotional BS.]

Given that most of the people who read this will never raise money from the individuals/funds we refer to in the prior paragraph, these groups are also setting people up for failure as they go in asking for “non-standard” terms and find themselves getting left out in the cold by investors who actually know what they are doing. The self-serving effort to seem like god’s gift to founders by telling people to seek terms that very very few entrepreneurs could ever get is a disservice. The reality is that most founders who could get these terms are smart enough to select investors based on an earned reputation and value-add, not their willingness to take it on the chin with deal terms, and these founders will craft terms that are fair while at the same time recognizing the premium they can and should command based on prior success and experience.

Based on a whole lot of direct experience we strongly recommend a Series Seed round vs a convertible note or SAFE, although none of these will wreck your company before it gets rolling. Before we outline why this is our recommendation, we will explain what the heck the three (current) main structures for a seed financing are, the key components of each approach, and our assessment of the Pros and Cons from both a founder and investor perspective.

Series Seed Preferred

Raising a Series Seed financing means you are creating a new class of stock on your cap table (Series Seed) and when you close on the capital you are adding equity investors in your company. This means that all of the terms and conditions of their equity ownership will be defined in the financing. In addition, a whole lot of things that don’t yet matter, like investors rights following an IPO, will be clearly defined, as will a lot of things that do matter such as the make-up of your board of directors and decisions that will require voting approval by your Series Seed investors.

As with all of the financing structures, there are Pros and Cons to this approach:

Pros. Raising a Series Seed has a number of positives, most of which are longer term factors, but since you are building your start-up for the long term (right?) these should carry a lot more weight than the short-term considerations.

Pro #1. One clear positive is that you will have “set the table” for future financing rounds and if things go to plan you can expect the key terms in your Series A, B, C rounds and beyond to largely be based on the terms set in your Series Seed financing. This will include liquidation preferences (1x non-participating please), anti-dilution protection (broad-based), board structure (it will change round by round but setting the table for this early makes a lot of sense for founders) and various voting rights that provide potential blocking/control rights over some decisions.

Pro #2. You know how much dilution you will have from the financing round. This is not the case with a convertible note or SAFE and we have seen a lot of situations where the founders raised capital on a note thinking the cap on the note was the valuation, only to raise a round at a lower price and take it on the chin. We have seen even more situations where a founding team raised on a note and then raised a bit more and a bit more after that, but because these did not show up on the cap table they never fully considered how much dilution they were going to take when these all converted to equity. It is easy to lose track of this with notes and sucks when the bill comes due (conversion to equity).

Pro #3. It is a more professional approach to raising capital that will put you in good stead when you raise future rounds because you will have A LOT more of your “ducks in a row” as a result.

Pro #4. Future investors will have a clear sense of your cap table and will not have to deal with the challenges of note conversions and the impact the notes have on pre- and post-money valuations, liquidation preferences, anti-dilution protections or anything of that sort. Investors in your Series A are highly unlikely to take dilution from the equity that is converting so it will all be rolled into the pre-money valuation. This makes sense since this is not new capital going into the round but is sometimes overlooked and makes a big difference in terms of dilution.

Pro #5. Converting notes into a future financing is a total pain in the a**. This is especially true if you raised capital at different “caps” and at different times. It requires herding a lot of cats, often results in you having to try to change some of the terms of the note (or SAFE) to conform with the equity round these will convert into, and sucks up a lot of cycles for no reason.

Aaand, there are some counter arguments (cons) to the Series Seed approach as well…..

Con #1. Time. In terms of time to closing a financing, the Series Seed approach will require more time because it requires an entire set of financing docs to be generated and reviewed. This does not mean the financing will take longer to close, it just requires more of your time and your legal counsel’s time to work through the process. This has been made significantly easier thanks to the “Model Legal Documents” created by the NVCA which are a great template but generally require a bit of tweaking.

Con #2. Cost. It will cost more in legal fees to raise via a Series Seed financing vs a note/SAFE. This is because a Series Seed requires the legal documents per above and because you are actually adding investors to your cap table and will need to revise things accordingly. The cost could be $5,000 to $20,000 more than a closing via a note.

Pause.  Con #’s 1 and 2 are the primary factors the zealots of alternative approaches use when trying to convince you to not raise a Series Seed. When an investor raises these issues you should question whether they actually are thinking about what is right for the long-term of your business or are just trying to make things “easier” for themselves and you in the short term but ignoring the potential long-term implications. We’ll give the counter-argument to these first two cons below.

Time – Taking a bit more time to do things the right way and set yourself and your company up for long-term success is a VERY good idea, especially when it comes to some of the key early decisions you make about the structure and capitalization of you company. This will be time well spent and you’ll get an incredibly important speed class in financing rounds and structure that will help you immensely in the future. You will also learn a lot about the investors you are considering bringing into your company.

Cost – This is perhaps one of the most idiotic “cons” we can think of. You are trying to build a multi-billion dollar company and someone is telling you to make a key decision based on the fact it might cost $10k more than the alternative? We’ve seen the same argument used to justify hiring a law firm that charges less by the hour but lacks experience working with venture-backed startups (note: this is a TERRIBLE DECISION – read this post to learn why). Spend the extra money and set the company up for an easier path in the future – remember, you are going to have to draft these financing documents eventually and if you do it at the Series A and have to factor in note conversions and the like, that financing will take longer and cost more to complete. If you have the legal docs in place from the Series Seed you will find the Series A process is MUCH MUCH smoother!

More cons of a Series Seed…

Con #3. Loss of Control. There is no doubt that this is actually the most valid argument against raising a Series Seed but is ironically not the one people usually bring up first. Bringing investors onto your cap table means they’ll have voting rights and usually will have the right to weigh in on some key decisions. This means you will not have as much control over company decisions as you would with note holders who have no voting rights. Our advice….

Get over it.

Unless you plan to never raise equity, in which case you should not waste your time reading any of our posts, you will eventually be bringing investors onto your cap table and will be ceding some meaningful level of control as a result. This is part of life when you raise capital and underscores the importance of raising money from the right investors. It is also something you’d be wise to get comfortable with early on.

The reality is that while you will lose some control with a Series Seed, this financing is likely the round where you have the best chance to dictate the terms of the financing and make sure the key items are structured in a way that you are comfortable with. Given it is highly likely your Series A, B, C and future rounds will mostly copy the key terms from your Series Seed, you are putting yourself in a much better position ahead of those rounds as new investors will have to negotiate against existing terms instead of against what you want a term to be. The former is a lot harder than the latter and if you are fortunate enough to have competing term sheets in your Series A you will find that all of them will be tied to the terms you set in the Series Seed, at least if they want any shot at winning the deal. (plugging our guest post titled “Negotiating for the Long-Term” here – worth reading for sure!).

Con #4. You have shareholders.  Having shareholders brings a new level of responsibility and means that you as the CEO and as a board member have to be looking out for the best interest of these shareholders. This is very different from a situation with note holders where you really owe them nothing other than to honor the terms of their note agreements. Our advice….

Get used to it.

Unless you are insane and not granting options to your employees you already have shareholders (or soon will) and eventually you’ll have a lot of them. This is a normal fact of life in companies so why not start adjusting to this reality now instead of down the road? You’ll find that your legal counsel will be just that much more careful with board minutes and resolutions and this extra level of attention will be a good thing for you in the long term as you scale your company.

Convertible Notes and SAFEs.

The reality is that convertible notes and SAFEs are very similar in terms of how they are set up and how they convert into equity, with one VERY important difference that makes SAFEs a better option for you as a founder.

Convertible Note vs SAFE (Simple Agreement for Future Equity):

A convertible note is a debt instrument, which means that until it is converted to equity your company has outstanding debt obligations that will accrue interest until repaid or converted. It also means that if things do not go to plan you may well have a legal obligation to look out for the best interests of these debt holders over shareholders. It is debt and you have to repay it unless you close a qualifying financing so that the noteholders become shareholders. Because this is debt there is going to be an interest rate applied to the notes that also has to be repaid, or if the notes are converted to equity, will be added on top of the note so the noteholders will receive additional shares of stock at the time of conversion – the longer the time between closing the note and conversion to equity, the higher the accrued interest.

A SAFE looks very much like a convertible note with the key difference that a SAFE is NOT a debt instrument. The primary value of this is that you do not have to ever repay a SAFE (unless an end date term is added into the agreement).

Because of this, SAFE notes also typically do not include any sort of value accrual (interest for the convertible note), so regardless of how long you go between the SAFE and the conversion to equity, the total value of what is converted will not change.

UpCounsel wrote a VERY detailed article on SAFE’s that is worth reading if you are considering this path.

As SAFE’s have become more common the terms have been changed to make them acceptable to professional investors so in many ways they look more like convertible notes in terms of some of the protections put in place for investors (the original SAFE structure had holes you could drive a truck through if you wanted to find ways to screw over your investors – if this is of interest to you then please close this tab and never look back).

Between the two we’d recommend going the SAFE route but you may get pushback from investors who want to accrue value and put some modicum of time pressure on you for a conversion to equity. Either is fine but the SAFE is probably a better bet and you can adjust terms to address the most common concerns investors will raise.

Quick note on valuation caps….  A convertible note and SAFE structure will either have a pre-set valuation that is the maximium value for conversion to equity (a capped note/SAFE) or will have no limitation on the valuation at time of conversion.  In both cases there is usually also a minimum discount applied to the conversion based on valuation of the next round (20% discount seems to be the norm).

If you are planning to raise an uncapped note or SAFE you are in a very small % of founders and we hope for the sake of the ecosystem that you get turned down and forced to use a cap because we think uncapped deals are moronic and show a total disdain for the investors you are considering bringing into your company. Odds are that if you do pull this off you will regret it down the road because very few smart investors would sign up for a deal where their best case scenario is they give you capital to grow your company, take 100% of the risk in that process, help you grow your business and then get rewarded by converting at the same price as new investors after a bunch of risk has been removed. That is seriously a really stupid investment decision.

For the other 99% of you, decide on a valuation cap that is reasonable for the stage you are at plus a bit of a lift above that (worth seeing if you can get it and you won’t unless you ask).

Pro’s and Con’s of convertible notes and SAFE’s:

Pro #1: Simple. You can draft the agreement for these structures in minutes and finalize a deal in a matter of days with very little brain damage along the way. Simple and fast. If you are planning to raise money from a lot of individual investors then this is the right path to take, even if raising money from a lot of individual investors is almost never the right path to take (comment on this article if you want us to write a post on this). Also, because there is no interest, you can close SAFE notes on multiple days without making future conversions hard. This works very well in the Y Combinator funding process but is not what we’d recommend for most companies in terms of closing process.

Pro #2: Cheap. You can probably do this yourself with just a quick review from an attorney because the SAFE template can be found on multiple websites including Y Combinator (which is awesome, btw). That said. you’d be wise to have legal counsel manage the process for you. It costs very little to get this done.

Pro #3: No Shareholders Added. If you consider this a positive result than go with that but then you really should check yourself in terms of your comfort level giving up control in your company in the years ahead. It does simplify things for the time being though.

Pro #4: Valuation. It is possible you can get a better valuation cap going this route than you will get in a Series Seed. Just remember that valuation cap DOES NOT EQUAL valuation and you will have to create value in the business in order to raise a future round at or above the valuation cap. The reality is this can be a major con as we noted above in the Series Seed section.

Now the Con’s….

Con #1: Simple and Cheap. Build your company for the long-term and build your investor base and cap table accordingly. In this case simple and cheap on the front end can become a serious headache down the road and may ultimately require more time and money than you initially saved.

Con #2: Dilution. Even though it will not show up on you cap table, do not forget about the dilutive impact of a note or SAFE and remember that the valuation cap is not a sure thing in terms of where this money will eventually convert to equity.

Con #3: Chaos. Tracking notes and SAFEs and dealing with conversion process in you future financing can take time and be a serious pain. It also means you are lacking a lot of the structure that you will eventually need to put in place and bridging the gap between a simple note agreement and an equity financing can create some pitfalls.

IMPORTANT NOTE: Make sure you draft your SAFE or Convertible note so that liquidation preferences for the the holders of these instruments are equal to their price per share (typically the valuation cap or discount), and are NOT the same as the Series A price per share. This would give these holders a better than 1x preference. By the same token, make sure their anti-dilution protection IS the same price as the Series A. Your Series A will require both and it will be a complete pain going back and asking to change this, so make sure to get it right up front.

Con #4: Side letters. Unless it is for an investor putting in a significant amount of your seed round (rule of thumb – half the total being raise), just say no if anyone asks, especially pro rata side letters and MFNs. These just add to the chaos and complexity when it comes to your next round. Side letters often include special rights for future investment, board participation and other “rights” and you will always regret agreeing to these, so don’t. No one investing $50k or $100k in your start-up should get special rights and the reality is that if they ask for them you should move them down your list of potential investors.

Time to Choose

While we recommend the Series Seed approach. we are not overly fixated on this and have invested in seed stage companies using all three structures and others as well (favorite was handing a physical check to a founder and asking them to send over an agreement if they wanted to take the capital – it worked out VERY well for everyone).

While each approach has its pros and cons, the world will not (likely) end regardless of which structure you decide to use in your seed financing.

That said, we recommend you go the Series Seed route as it is the best approach for setting your company up for long-term success as outlined above.

No matter which path you choose, good luck with your financing round!!!

NOTE: We welcome comments and feedback on this and other articles. We curate the comments only because of the high level of spammy messages that get posted on comment boards. If your comment is relevant to the topic we’ll post it, whether we agree with you or note, so PLEASE let us know what you think!!