Introduction

When navigating the complex landscape of startup financing, one common question that arises is the split between convertible notes and equity in a typical seed round. This article aims to clarify the intricacies of convertible notes and equity, and how they typically function in the context of a seed round.

What Are Convertible Notes in a Seed Round?

Convertible notes are a type of funding instrument that offers startups a way to raise capital without the immediate pressures of a comprehensive equity valuation. Typically, convertible notes are used as a bridge financing solution to bridge the gap between an initial round of seed funding and subsequent equity rounds. These notes can allow investors to hold onto their investment until the company becomes more established, at which point the notes can convert into equity based on a predetermined valuation (usually referred to as a cap).

Why Convertible Notes Are Not Used in Conjunction with Direct Equity Investment

The primary reason for the distinct nature of seed rounds is the tension between convertible notes and direct equity investments. Convertible notes are designed to be temporary; they are a stopgap measure until the startup is ready to raise a comprehensive equity round. Mixing convertible notes with a direct equity investment can lead to complications in valuation and ownership dilution, making the structure less efficient and potentially detrimental to both the startup and its investors.

The Typical Financing Structure in Seed Rounds

Typically, a seed financing round is structured either as a direct equity investment or as a convertible note. While the two forms of funding can coexist in a financing round in certain contexts, they are generally not combined in the same seed round. If a seed round does include both convertible notes and direct equity, it would be unusual and could indicate an unconventional financing strategy, which is why it is important to understand the unique circumstances behind such a structure.

How Convertible Notes Convert to Equity

When a startup is ready for a new equity round, any outstanding convertible notes will generally be converted to equity based on the agreed-upon valuation. The amount of equity received will depend on the original terms set out in the convertible note agreement, such as the conversion multiple and cap. This conversion process serves to simplify the financing structure and ensure that the notes holders’ positions are equivalent to direct equity holders.

Practical Considerations and Real-World Examples

While it's uncommon to see both convertible notes and equity in the same seed round, there are scenarios where hybrid structures have been successfully implemented. For example, a startup might raise a portion of its funding through convertible notes to secure initial capital and then pivot to a direct equity round to secure further investment. However, this is a specialized approach that requires careful consideration and planning.

Conclusion

Understanding the split between convertible notes and equity in a typical seed round is crucial for entrepreneurs and investors alike. Convertible notes serve as a stopgap measure, allowing for simplified fundraising before a more comprehensive equity round. Mixing these two forms of funding is generally not ideal due to potential valuation and dilution issues. Therefore, it's important for startups and investors to clearly align on the financing structure to ensure the possibility of a smooth and efficient fundraising process.