In the context of angel investment, one question that I get on a regular basis is whether investments should be structured as preferred stock or convertible notes. As with every question that you ask a lawyer, the answer is "it depends." Here are some thoughts on the merits and demerits of each:

Preferred Stock

Preferred stock requires that the investor and the founder agree to a valuation. In the very early stages of a business, this can be very hard to do. Having said that, if you know of companies that are comparables for your company and that have issued preferred stock, there is a good chance that we (Foley or your lawyer) can make a pretty good educated guess as to the valuation.

Preferred stock is expensive from a transaction cost perspective. The documentation is generally longer (more pages) and more involved than notes. Also, some angel investors that buy preferred stock will want to have all the whistles and bells that VCs ask for. This is particularly true of organized angel groups. If you are raising a small amount of money the cost of such a transaction can be exorbitant.

Convertible Notes

Convertible notes do not require a valuation if, as usually the case, they are structured to convert into the next equity round at a stated discount to that round. Discounts seem to range from 10% to 40% but in my experience the mode is 15% or 20%. The down side is that you have to consider what happens if there is not a next round or what happens when the next round lead investor objects to the participation or the discount.

One answer to the question of what happens if there is not a next round is that the notes become due and payable. Another, perhaps better for the company, is that the notes convert to common stock at a favorable valuation (favorable to the noteholder that is).

The answer to what happens when the new lead investor objects, is that there will have to be a negotiation. Experience indicates that somehow someway you will work it out.

As to transaction cost, unsecured convertible notes are just easier to document than preferred stock. So, if you are raising small amounts (below several hundred thousand dollars) and transaction costs are an issue, go with notes.

Final thought

Sometimes you have to take your money where you can find it. You may find that there is a lot of merit in giving the investor what she wants and closing compared to spending time and dollars to structure the perfect deal.