The Convertible Debt Seed Financing

The trend in seed series financing is to use convertible debt rather than preferred stock. Well reasoned articles on point are here and here but below find a summary of the issue.

The explanation begins with distinguishing the fundamentals of the two forms of financing. Convertible debt works as follows: it starts as just a loan - a right for the lender (in this case an angel investor) to get his money back plus some interest - but changes (or "converts") into a right for the lender to receive stock (of the equivalent value to the loan) at the occurrence of some future event (usually, the next round of financing). Preferred stock on the other hand is just stock, albeit with special economically advantageous liquidation and preference rights as well as certain control rights and that is usually convertible into common stock ("stock" stock, like the kind you buy on eTrade).

If all things are equal, convertible debt militates to the company's advantage, and in a big way. If a company is roughly worth $100K, for example, and Joe Angel gives $50K in exchange for $50K of convertible debt rights, and a year later Sequoia Capital gives $10 Million of Series A at a $20 Million valuation, then Joe Angel's debt converts to $50K of stock, or less than 1% of the company. By contrast, if Joe Angel had received preferred stock, he'd own 50% of a $10MM company prior to the investment.FN1

To correct for this outcome, however, investors now typically require a "cap" or control on the conversion ratio. Other blogs have detailed precisely how this works (the usual mechanic is that the investor gets the better of i) a capped valuation (no matter how high the future Series A valuation is the conversion calculus will hypothesize the valuation to be some predetermined lower amount and ii) some additional multiple (like 2x) of their investment) (both give the investor a higher percentage equity ownership) but the upshot is that the conversion calculus is usually rigged such that ownership levels approximate a preferred stock seed financing.FN2

And yet, convertible debt remains the better option for companies, for two reasons. First, transacting/paperworking a convertible debt is at present simpler (no voting rights agreement, no investor rights agreement, etc.) and therefore cheaper (the usual numbers kicked around are $5-10K versus $25-30K but as model seed series docs become increasingly available this discrepancy will probably diminish) and second, there's no need to perform/argue about an initial valuation of the company.

FN1. What happens if the Series A financing never happens? Usually, a company with no money and no prospects owes the angel investor $50K plus interest. People will move on. 

FN2. One commentator asserts that convertible debt with a cap IS a "priced equity round" or preferred stock financing (due to the way the accounting ends up delivering to the investor the (roughly) same ownership percentage).