Continuing our “Ask the VC – Startup America” series after a bit of a blog hiatus (we have closed 3 deals in the last 3 months), this was a popular question that I still hear a lot:
“As a very young startup, with a validated concept and freshly built app, will raising from angels on convertible debt with a price cap hurt me? Also, does it matter if we are an LLC or a C Corp?”
For the first question, the answer is no. Raising an early convertible debt round will typically not hurt you in future fund raising endeavors. This is a commonly used structure that many entrepreneurs use in the early stages. The reasons are twofold; first it allows you and the investors to not have to set a valuation on the business at this stage when many of the early questions on customers/users, etc. are not answered. Second, it is simple and cost effective to do and can measurably decrease the time needed to get a financing done.
On the valuation point, a convertible debt round can be beneficial for the founders and other employees in terms of potential early dilution. If at the first equity round your valuation is higher than it would have been prior to the convert, then most times you will be a net winner. With this being said, the angels also benefit by typically getting a discount on their conversion to the first equity round, effectively giving them a risk premium for financing at the early stage. Because it’s pretty straightforward and usually pretty clean, it’s an easy structure to get done, doesn’t involve much legal advice (forms are readily available online) and is commonly used.
Now what about a Cap? Caps (dollar amount thresholds that are used for the price conversion) are meant to protect everyone in case the valuation gets pricey at the first equity raise. It also provides protection in the case the opposite comes true and the company can be financed, but only at an extremely unattractive valuation; instruments can be used to protect the founders equity from being over-diluted. For those who take the early risk, they are betting that they will end up with a fair equity share when there is a conversion. If the valuation gets really high, let’s say $50M-100M like we’ve seen recently with some Social Media companies, then the early angels may end up with a very small percentage of the equity, even with their discount – not very attractive considering they took all the risk. Therefore, caps can be used to protect the investor downside on the ownership. Keep in mind this can complicate the next round of financing, but can usually be worked through.
As far as an LLC vs. a C Corp, most equity financing done by VCs are into C Corps. This doesn’t mean we won’t invest in an LLC (we just actually completed 2), but eventually those companies will need to be converted prior to an exit. Seek legal advice here as there is a potential tax consequence associated with these structures you should be aware of.
In case you missed the first two posts from Ask the VC: