Seed Round Funding: Don’t Get Hosed on Terms

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Chris Dixon has an excellent post on his Blog about on seed round funding and the deal terms which create the correct incentives for both investors and founders.

Overall, I agree with his ideas, but founders should recognize the difficulty they may have in achieving these favorable terms in today's difficult funding environment. It helps to have a good lawyer on your side to make it happen. I agree with Chris that Gunderson is an excellent choice, having used them in many of my portfolio companies.

A few additional observations:

Use of Convertible Debt–Instead of (or in addition to) common stock as the initial instrument to fund operations, consider using a simple convertible debt instrument with pro rata rights for seed investors. I have successfully used convertible debt, with or without warrant coverage/interest provisions in most of my seed round funding. Angels often feel more comfortable with debt preferences versus common share equality with the founders. The incentives around successful launch and Series A funding remain the same for founders and investors with debt financing. Note: Chis is not a big fan of convertible debt. His recent post on the subject is re Blogged below.
Valuation–Perhaps the most difficult "term" to negotiate in the current start up funding world is the worth of the company. Chris makes a good point and one that bears emphasis. Don't overvalue your company in the seed round and then have to accept a down round in Series A. Not only is it demoralizing to founders and employees, but you get marked with a scarlet letter (remember Hester Prin?) in the venture community and future rounds become even more difficult. Take Chris' advice and choose a rational valuation number you can beat in the Series A round.
Liq Pref–A 1X liquidation preference should be the standard. Period. Unless someone out there can give me a good reason why higher first round investor preferences are critical to the success of an early stage start up.
Ownership–The amount of company an entrepreneur will "give away" during initial funding is closely tied to valuation and seed round investment levels. Be prepared to have even angel investors want up to 40% or more of the company in the seed round. The more you can self fund, develop beta software, get grants or SBIR loans, have initial customers, etc. before you approach angels the better. This is the new economy and DIY is big among start ups who want to preserve ownership. Besides, on-line and often free tools allow faster and cheaper software development, breaking the old cycle of 18 months to market for start ups.
Chumming the Waters–make sure your seed investors are able to continue supporting your company in future rounds, in case new funding sources become problematic. Some angels and early stage VC's "chum the water" with lots of small investments, then focus on only a few for real funding. Early stage funds who decline to invest can create negative market perceptions of your company.

A VC in Vacationland

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