One of the most significant sources of confusion faced by NYC tech entrepreneurs in structuring their seed rounds is that content available online, particularly from Silicon Valley (which tends to operate by its own unique norms), can create a false impression that everything has been cookie-cutter “standardized”. This is far from the truth. Investors have different priorities, as do companies, and they are all raising in different contexts. That means flexibility is key. The goal of this article is to give founders a high-level understanding of the most common structures available for seed funding, so they can then work with trusted advisors to put something in place that works for their company.
At a very high level, New York seed financing structures can be broken down into two broad categories: convertible securities and equity (stock). Convertible securities are shorter, simpler, and therefore much faster to close on, but the cost of that speed and simplicity is that they defer lots of key economic and power-related discussions to a later date (when the security converts into stock). Equity rounds are more complex and time-consuming to close on, but they provide more certainty upfront, which some companies and investors can find valuable.
The two main types of convertible securities are convertible notes and SAFEs. While SAFEs (which are effectively convertible notes without maturity dates or interest) gained a significant amount of traction in California, and some traction in other markets, recent very material changes to how their economics work have caused them to start falling out of favor with startups. See this article for info on that.
Convertible notes are in our experience by far the most dominant convertible security instrument for seed rounds. We recently published a template form of convertible note, based on hundreds of deals we’ve closed across the country, for ease of reference and redlining. The most important issues in structuring a convertible note round are (i) ensure the maturity date gives you enough breathing room to hit a needed milestone (2-3 yrs is the norm we see), and (ii) ensure you understand exactly how the conversion economics work. Nuances around how the conversion price is calculated, including the capitalization used in calculating the conversion price, can heavily impact the level of dilution that you are hit with.
While convertible securities are favored by companies who want as fast of a closing as possible, speed isn’t always the top priority; for companies or for their investors. Particularly when you have one seed investor putting a significant amount of money into the company (as opposed to a more diversified mix of seed investors), that lead investor might insist on getting more detailed rights up-front, which leads to discussions about an equity round.
Within the equity category, there are two types of structures: full “NVCA-style” equity docs and simplified “seed equity” docs. The NVCA is an organization that has played a large role in publishing loosely template-ized legal language for VC financings. Under that structure, you are effectively using the exact same kinds of documents that would typically be used for a Series A, but calling it a seed round. These documents are far longer and more complex to negotiate than a convertible note or seed equity, but the reality is that some funds will insist that you use them if you want their money. We’ve found that it’s much more common for investors to push for this style of structure when the round is $2M or larger in size.
As a kind of “middle ground” between convertible securities and NVCA-style equity are “seed equity” documents. They are far more slimmed down than the NVCA, but still provide more rights than a convertible security. Their simplified nature also allows the round to cost about 1/4th to 1/3rd of what you’d spend in a full NVCA-style round. While they are hardly a majority structure, we are seeing seed equity increase in popularity among seed investors and founders, because they can provide a good balance between speed/efficiency and certainty on rights.
The Details Matter
In structuring their seed rounds, founders are working with very high-stakes and highly complex terms that will have a permanent impact on their company. The details matter. Ensure that you have highly experienced and trustworthy advisors, including counsel, to rely on in helping you determine what structure is best suited for your context. Steer clear of anyone pretending that it’s in your best interests to just mindlessly sign a template (usually one they or another investor drafted) and move on.
In the case of counsel specifically, ensure that they do not have conflicts of interest with the money across the table, and that they have years of specialized experience in this exact field, so that you can trust the advice you are getting. By working with leaner boutique firms, whose rates are hundreds of dollars an hour lower than “unicorn” BigLaw firms for very experienced and well-credentialed lawyers, you can also ensure that your budget goes toward real advisory and negotiation; instead of institutional overhead that you simply don’t need.
For a deep-dive into issues you’ll face in seed rounds, see: Seed Rounds.
Jose Ancer (@ancerj) and Jeremy Raphael (@jraphs) are Emerging Companies Partners at Egan Nelson LLP (E/N), a Lean, World-Class Law Firm delivering top-tier, scalable legal counsel to leading startups, without the unnecessary overhead costs associated with traditional firms.