Should a startup company raise its seed round using a convertible note or Series A Preferred Stock?

Generally speaking, founders of a start-up company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A round, the valuation is most likely going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People who are good at using Excel should try to model the different scenarios.
2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A, though this is not always the case.

However, there are two principal reasons to dislike convertible debt from a founders’ perspective:

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A round to be low so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.
2. Investors may request aggressive terms. For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, and drastic measures upon an event of default (i.e., the equivalent of having your arms broken if you don’t repay), among other terms. In a Series A financing, there seems to be some established norms on what is considered typical, while in a convertible note bridge financing, creative investors may suggest some unusual terms.

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