The Case For Priced Seed Rounds

When I was a kid, there were a series of memorable commercials from a company called Fram which made automobile oil filters. The message behind all of their commercials was that you could pay $4 for a quality oil filter today or pay hundreds or more to fix your engine later. If you’re over 45 you’re smiling now. If younger, here’s an example:

These commercials come to mind as I’m witnessing the effects of the proliferation of capped convertible note seed rounds. Mark Suster, Brad Feld, Duncan Davidson and others have written insightful pieces lately about the downstream challenges these notes are causing entrepreneurs when it comes to raising subsequent capital. Click on their names above to read them.

When I started in the venture business, you rarely if ever saw a convertible note. Today, it’s the priced seed round that’s rare. There’s no doubt that a convertible note makes life easier for a founder when raising a seed round. First, most founders believe their seed-stage startup is worth more than they could fetch in a negotiated priced round and the capped or (god-forbid) uncapped note is a great vehicle which allows an entrepreneur to grow their company into a higher valuation. Second, it allows them to delay what they perceive to be an uncomfortable valuation discussion. Solution? Throw a cap on a note and kick the can down the road.

Sadly, I’m watching this strategy come back to haunt so many founders going out to raise their seed extension or Series A rounds because of the inflated post-money valuations their companies are now sitting at as a result of their capped notes. Most entrepreneurs I know haven’t taken the time to fully understand the implications of these notes. Even at Techstars where we teach our founders about this, I still see mostly capped-note seed rounds. I get it. It’s easier.

My advice? Price your seed rounds. It was done for decades and it worked. It leaves no ambiguity and all the investors know exactly where they stand. Most importantly you’ll have no cap table issues when it comes time to raise your next round of capital. Is it a little more work to get this done? Yup, but tell me anything worthwhile that doesn’t cause some discomfort. Most founders I know don’t take the easy route when building their products because they know there’s negative downstream effects of that strategy. Why do it when raising capital?

What’s the cost of doing a priced seed round? Well, you’ll have to find an investor who will A) be willing to price your round (usually your largest investor) and B) you might not get the valuation you were hoping for. The former shouldn’t really be all that difficult and there’s reams of great posts out there supporting that the latter is irrelevant if you build an important, long-lasting company. So like the Fram commercial says, you can pay now, or you can pay later…

Showing 8 comments
  • Reply

    Just to throw in my $0.02 as a founder who raised $5M on notes… I would have happily done a priced round and the advice from YC was “if someone offers you a decently priced round, take it!” but this didn’t seem to be something angels wanted to do because whoever was gonna price it had to lead, and frankly I don’t think anyone really wanted to go to the trouble of figuring out the price for a $50K or even $100K check. A lot of convertible note trendiness is about it being a fast way, and a way to survive. From the founder perspective, this sounds like a nice optimization if you can get it but probably not the reality for a lot of us…

    • Mark Solon

      Yup, as I mentioned, I totally get it Danielle and I understand and empathize with the challenge. You outlined the most difficult scenario of getting a priced round, when your largest investor is $50K or even $100K. Usually, if you get a lead that’s $250K or greater, if you set your mind to it you can get to a mutually disagreeable price with an investor writing a check that size. The $500K – $2M round with 15-25 investors (so many of those these days) is indeed a hard one make this happen.

      • Reply

        Hopefully I’ll never go through that phase again, but if I do I’ll work really hard to get a priced round. Frankly, a class $1-3M Series A would have been awesome.

        • Mark Solon

          The funny part is that it really wasn’t that long ago that these note rounds didn’t even exist. The note round was cleverly created to solve a problem, but alas, how many millions of ways have we solved for a problem only to create new ones?

  • blakeyeager

    I really like the comparison to taking short cuts on product development, most founders understand the risks associated with that strategy, but most of the founders I talk with don’t really understand the risks associated with capped convertible debt.

  • Jake Chapman (@runvc)

    As a seed stage investor one of the problems I see with the convertible not trend is founders look around and see their contemporaries raising $1MM+ at caps of $5MM or more. They confuse the note cap with an actual valuation. This means when I come in and try to price their round fairly at something like a $3MM pre-money they (a) feel like I’m trying to screw them or (b) don’t want to be seen as raising at a lower valuation than all of their peers. The cap on a note is not a valuation but that is precisely how most founders think of it.

  • Dave McClure

    Mark: i appreciate the sentiment in wanting to reduce complexity & helping founders, however i’m not sure the answer to a lack of clarity around valuation & pricing when companies are still fairly young is to use a priced round to lock-in that lack of clarity.

    altho you can argue that it’s “bad / foolish” for founders to set “high” caps for their notes, at least if they are wrong about cap = valuation, they can still raised a round even if they may end up taking greater dilution than they want.

    however, if you do an EQUITY round with the wrong price, you may not even have the luxury of that uncomfortable option. many ventures investors will WALK AWAY from the next round if the previous equity round price is over-valued, and a recap or pay-to-play option is required to finance the company.

    more important than this, the hassle / time factor in doing a priced round may itself create timing issues that the company can ill afford if it’s trying to make sure it has enough capital to keep the doors open.

    anyway, i don’t think that the best answer is always to force an equity round and harden pricing when it’s a fuzzy issue.

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