A better seed investment structure

There has been a fair amount of discussion on seed / angel investment structures recently in the blogosphere. Below are two great postings that cover most of the discussion to-date:

  • Brad Feld – discusses the two main structures currently used, preferred equity and convertible debt with a warrant
  • Josh Kopelman – discusses the positives and negatives of each and when to use one over the other

I think Josh’s analysis is exactly right. I’ll illustrate a main reason why from a perspective of an angel. However, the added complication comes when you want to use the preferred equity structure. Most companies at this stage do not want to go through the hassle or cost of structuring a preferred equity instrument. Josh offers the NCVA standard documents, which is certainly an option.

After speaking with several angels I came across a structure used by a successful angel investor in the Austin area. The structure is a Debt Note and a Warrant. It goes as follows:

  • Debt Note is for a term of 2 or 3 years at simple annual interest, and is payable in full plus interest at the earlier of term of a financing event
  • Warrant is good for a fixed percentage of the company in its most senior equity security on a fully-diluted basis at a fixed price (which is the amount of the Debt Note); warrant has a term as well, maybe the same as the note maybe longer.

An example will illustrate how this works.

Say the seed round is for $200k and the postmoney valuation is $2MM (MM = Million). In this case, the debt note would be for $200k and the warrant would be for 10% of the company ($200k/$2MM) with an exercise price of $200k. If the company raises a Series A round for $10MM postmoney valuation, the angel is paid his debt note back and can exercise his warrant for 10% of the company by paying $200k. The reality is this can be a swap of the note for the warrant so that no cash need change hands again (i.e. the company simply keeps the angel cash and the angel gets 10% of preferred equity).

This effectively puts a valuation on the Seed round, but Josh addresses that issue well in his post. There is no need to structure the preferred equity terms here, since the angel simply assumes the most senior security at the time of conversion.

The angel with whom I spoke allows the exercise of the warrant to happen any time during its term (which may be up to 5 years). So, in this event, the exercise isn’t forced at the next financing event, but it could be 1 or even more financing events later than that (e.g a Series C or D round) and still be good for the fixed percentage ownership fully-diluted then. This is likely to be viewed as extreme, as it survives dilution through multiple capital rounds and gives the angel a free option since his note is paid back. I have not grappled with that yet, but the right solution may be an exercise of the warrant at the first financing event.

In addition to the misalignment of interests between the angel investor and the entrepreneur, the other problem I have with the convertible note with warrant coverage structure is the implied valuation. This is probably why one of Josh’s cases for using this structure is "when a venture round is imminent or already underway" and a timing of "60 days or less to close." If it falls outside of these parameters, the valuation of the company on this structure is way too rich.

Let me illustrate. Again assume the company can raise a venture round at $10MM postmoney valuation. Let’s also assume $200k is invested in the seed structure of convertible debt with 40% warrant coverage (the high end of Josh’s range). I’m ignoring the interest since it’s negligible. In this case, the angel will own 2.8% of the company ($200k plus $80k warrants divided by $10MM). The implied postmoney valuation is $7.1MM (take $200k in actual cash invested divided by 2.8% ownership, which includes the warrants).

$7.1MM is pretty expensive for an angel to be paying for equity in a startup that isn’t on the doorstep of venture funding. You can run whatever numbers you would like in this structure and it’s hard to realistically get below $5MM. These are VC valuation levels and can be handled since the VC typically has enough money to carry the company to profitability and has a distributed portfolio to diversify risk. Angels typically have neither and thus play early to get better valuations. Seed investments typically are in the $1MM to $3MM range of valuation (except for those that are bridges to Series A as Josh illustrates). For $200k this get an angel 6.7% to 20% of the company depending on the valuation. A far cry from the 2.8% range on the convert w/warrant structure.

This is new and in evaluation for potential use by me right now. I’m eager to get comments and feedback.

— bkm