“Your First Vehicle for Fund Raising: Convertible Notes or Preferred Stock?”

“I think we need about $1,000,000 to $2,000,000 for our first round of funding.   Should we use convertible notes or issue preferred stock?”  This is one of the most common questions we get from entrepreneurs looking to raise their first round of outside funding.   When deciding between convertible notes or preferred stock, consider these key factors;

1.   Valuation.   You and your potential investors may have a very different view on the company’s valuation.  In a preferred stock round, the equity you sell to your investors is based on an agreed upon valuation for the company.  You may think your business idea is the next best thing since sliced bread, but your potential investors, who likely have seen dozens if not hundreds of deals, will base their valuation on where they think your company stacks up compared to the last few deals they have done.   One way to somewhat defer the valuation discussion is to use a convertible note, which provides for the conversion of the face value of and interest on the note based on the pricing in the next financing.   Typically, the investors in a convertible note receive a discount on the next round of pricing to compensate for the risk of investing earlier in the company.   Since “hot” investments can command significant valuations in a subsequent priced round, many investors will also insist on a capped conversion price (i.e., a “cap”) for their convertible notes, regardless of the valuation in the priced round.  While a cap does imply a maximum valuation for the company, it is generally far higher than what the company could have received if the round was priced.

2.  Amount raised.  The larger the investment, the more likely that the round will be structured as a preferred stock financing.  While angel investors (high net-worth individuals) and super-angel funds regularly invest in convertible notes in anticipation of the next round of funding, venture capital investors will virtually always invest in a preferred stock round.   Certain venture capital investors may come into a convertible round if they are interested in the company but are not quite ready to cut a multimillion dollar check.  Generally speaking, convertible notes will be used to document rounds raising less than $1,000,000, while preferred stock financings are more common for rounds of $1,500,000 to $2,000,000 and higher.

3.  Speed of execution.  A preferred stock round usually requires a fair amount of paperwork that is then subject to negotiation between the parties.  In addition, the investors in a preferred stock round normally conduct a thorough due diligence process.   In a preferred stock round, once the terms have been agreed to, it may be a number of weeks (or at times over a month) before the investment is completed.   In a convertible note financing, the process is faster, sometimes taking just days, once the terms have been agreed to.   The documentation is far simpler and the diligence process is far less involved, particularly if your investors are angels or super-angel funds.   In many cases, the paperwork may be limited to a convertible note that the company can process directly with its investors without the involvement of counsel.

4.  Cost.   In addition to the costs related to the drafting and negotiation of the preferred stock financing documents, the company will be subject to a thorough diligence process and often required to tidy up various corporate records, including legal, accounting, and tax.  Since the legal documentation and diligence process in a convertible note round are far less onerous than a preferred stock financing, the costs for a convertible note round will be a fraction of those of a preferred stock round.  If you are considering raising $1,000,000 or less, you and your investors should consider using a convertible note structure rather than a preferred stock financing in order to keep the process fast, simple and economical.