In the third and final installment of this blog post series, we’ll return to last week’s question (Should I sell convertible debt or equity?), and consider the other side of the coin: choosing equity instead of debt. We’ll need to ask the gating question, though: What type of equity? Common or [seed] preferred stock?

Why not issue common stock for invested dollars? While this is sometimes done (for example, accelerators often take common stock in exchange for a modest investment of $15k – $25k), most investors pushing to have a “priced round” (receiving equity for their investment instead of convertible debt) will want an equity position with senior rights to common stock. At a minimum, they will seek a “liquidation preference” to the common stock, which is at the bottom of the food chain of rights to corporate assets upon a liquidation or sale of the company (i.e., senior debt –> unsecured debt –> preferred –> common).

Additionally, from the startup company’s perspective, selling common stock to investors soon after formation at a particular valuation can create unwanted tax concerns for founders who are issued the same common stock upon founding of the company, typically for a per share price of par value of a thousandth of a penny or even less. Tax authorities could later challenge the company’s determination of the price at which the company sold or granted such common stock to founders, finding that such price is too low in light of the [much] higher price at which the company sold the same common stock to investors.

Finally, another related tax concern for the startup company: selling common stock to investors establishes a fair market value of the common stock below which the company may not set the exercise price of stock options. The company will likely want to grant such options to consultants, employees and directors going forward. This equity, of course, is the life blood of the young company and options are the primary instrument used for compensation. The aim is to keep the price of these options as low as possible for as long as possible to maximize the upside for the recipient; a high price per share of common stock undercuts this objective.

Why is “seed preferred” stock issued instead of common stock?

First, let’s make sure we understand the difference between preferred stock and common stock. Investors who are issued preferred stock have certain rights senior to the “sweat equity” that common stockholders have. These include senior rights to proceeds on a liquidation or a sale of the company; rights to purchase certain amounts of stock issued at subsequent financing rounds to maintain their pro rata ownership of the company (“pro-rata rights”); anti-dilution rights that protect the investors if the company raises more money in the future at a valuation lower than the investor paid; certain protective provisions (i.e., “veto rights” of certain major actions of the company); and possible rights to a board seat, among quite a few others. (See the NVCA form for a good example of a Series A term sheet that shows the variety of potential rights and protections for a preferred stock investor).

Seed preferred (also referred to sometimes as Series AA), differs from traditional Series A, B, and C preferred; it is stripped down and has a limited number of investor preferences and protections. A number of law firms with active practices of representing startups are each pushing their own set of seed preferred stock financing documents, each with the support of various particular active early stage investor(s). As such, there is no clear standard yet. What most seed preferred documents have in common, however, is a simple “1x non-participating” senior liquidation preference to the common; simple protective provisions; weighted average anti-dilution protection (sometimes); pro-rata rights; a guaranteed board seat (also sometimes); and basic information rights. The idea is that the investor will become a shareholder at the time of the investment, knowing how much ownership he or she will have in the company, but to save on complexity, time and legal fees, the investor(s) and the company agree to keep the terms and documentation relatively simple. Additionally, some of the seed preferred forms also have a provision that the seed preferred will obtain the same (presumably superior) investor rights negotiated by the Series A investors at the time of the Series A round. I think this provision can make sense: it helps keep the negotiation of the seed preferred documents to a minimum, although in hindsight post-Series A can make the seed preferred stock feel even more “expensive” from the company’s perspective.

Advantages to equity over debt. Certainty. The company knows exactly what it gives up for the investment, and the company and its investors are pulling in the same direction. This creates as much value in the enterprise as quickly as possible. If investors will only accept convertible debt with a price cap, there is an argument just to issue the seed preferred at the same valuation as the price cap. This strategy dispenses with accruing interest and a potential obligation by the startup to pay back the debt if a qualified preferred stock financing does not materialize during the 1 ½ to 2 years of a typical convertible note term.

Disadvantages to equity over debt. Despite investors’ and the company’s best intentions, as stock is being issued with a variety of stockholder protections and rights, negotiations can stretch, too, adding to legal fees and time to a closing. Also, the company loses the ability to delay the valuation negotiation; if there was no price cap associated with a potential convertible debt financing, the founders arguably have given up a greater percentage of the company for the same amount of financing had the company been able to close a convertible debt round.

Bottom line. Personally, I typically advise my startup clients (probably not my investor clients) to issue convertible debt. On balance, it’s quicker, simpler, and much less to negotiate (and, yes, the legal fees are generally much less). It’s easier to continue to do “rolling closes” so a company can take an investment check when the investor is ready without waiting until a “subsequent closing.” That said, a price cap (i.e., where the company agrees on a maximum valuation at which the convertible notes will convert into equity) can change the calculus, as it eliminates one of the biggest advantages: it delays setting the valuation for the investment, as it is effectively a “priced round.” Back to the above, however: a great investor can trump the bias. If you are offered a “priced round” at a fair valuation from a great investor, my advice is to take the priced equity round.