Tuesday, October 12, 2010

Investor - Want an Equity Seed Round? Pay For The Legal Fees

I know a number of investors who would prefer investing in an equity round over a capped convertible note for a seed round. (note, this post largely refers to seed financings)

Reasons investors prefer equity rounds include:
  1. Protective provisions and shareholder rights.  There are a set of terms that protect the investor that are negotiated into equity rounds that frequently don't exist in notes.
  2. Taxation.  If the company sells, there is different tax treatment to this investment if the note converts into equity upon acquisition then if the investor held equity the whole time.
  3. Sets the tone for the next round.  Often, some of the terms in an equity seed round will set the terms for follow on equity rounds.  This is often good for both entrepreneur and investor if the terms are set properly up front, decreasing the potential negotiation for future rounds.
The reasons entrepreneurs like convertible notes:
  1. Time - they are faster.  A convertible note ends up being 10 pages total between the note + purchase agreement, vs a thick stack of equity financing docs.
  2. Expense - they cost less.  (a) The entrepreneurs legal fees cost 2-3X more for an equity finaning then a convertible note, due to the increase complexity of an equity financing (and the legal time it takes to negotiate).  (b) For some reason the entrepreneur is asked to pay the legal fees for the investors in an equity financing.  Not sure if this strikes anyone else as ridiculous.  This means an equity financing can end up costing $35-$50K.  If you are raising $500K in seed, this means up to 10% of the cash raised for the business goes to pay legal fees.
  3. Terms.  See protective provisions above.
I find the fact that the company is asked to pay for the investor's legal fees in a seed equity financing to be kind of ridiculous.  This should be treated as a cost of business on both sides, and each should pay their own legal fees.

Thoughts?  Leave a comment in the comment section below.

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