|Issuing Equity (common or preferred)||Convertible Promissory Note|
|Key Features||Company can either issue common or preferred stock. Preferred stock has characteristics that set itself apart from common stock such as receiving dividends before common stockholders. |
Stockholders have the right to vote on certain matters such as election of the board and have access to the company’s books and records.
Stockholders have the right to receive dividends when declared by the board.
|Company issues debt to a note holder. |
Principal amount that is due at a maturity date.
Fixed rate at which interest accrues.
Converts to equity at a specified time/event: 1) at the next equity financing, 2) at maturity of the note.
Price at which note converts into equity usually at a lower rate than future investors as an incentive for investing early.
|Pros||The price and amount of equity the company is giving up is known.|
Sophisticated investors are familiar.
Can use the same documents for later equity financings, decreasing the cost of a later raise.
Avoid complication of figuring out how equity will convert in a note.
|Relatively short and less complex.|
Less terms to be negotiated.
Easy to explain to unsophisticated investors.
|Cons||Longer, more complex documents which require more negotiation and are therefore more costly.||The price at which the note converts into equity is not known when the note is issued.|
Notes that do not convert before maturity leave the founders exposed to paying the full amount or renegotiating with little leverage.
Other factors to consider
- Investor sophistication: The level of experience and knowledge of the investor will be a factor in what instrument a company uses to raise funds from that person and the complexity of the instrument.
- Investor preference: The company will often defer to the preference of the investor due to the company’s need for the funds at this stage of its life cycle. Deferring to what the investor wants decreases any friction caused through negotiations with the investor.
- Cost: Company’s at the seed stage are often limited on how much they can spend on legal fees and other costs associated with raising money. More complex instruments require more cost and vice versa.
- Time: More complex instruments take longer to draft, negotiate, and close. Whereas convertible notes are often standard and shorter documents that take less time. If the company is looking to raise funds quickly, it should take this into account.
Both of these ways of raising money at the seed stage for a startup company have advantages and disadvantages. It is important to weigh the pros and cons of each and think long term when deciding which instrument to use. As always, consult with legal counsel for guidance prior to beginning to the beginning of a raise.