Seed and angel investments often come in the form of convertible notes – often notes that are convertible into some future round of equity investment at a discount to the valuation at the time of conversion. They have other terms as well such as interest rates, maturity dates, prepayment premiums in the event of an early sale of the business, waiver of certain debtor protections etc. These all may form the focus of future posts. I want to focus on what, if any, influence seed/angel investors who invest in these types of notes want (or get) concerning the terms of the equity into which they are planning to convert.

First, there is little organized data around the terms of these (and other) seed or angel investments. This paucity of information exists because the deals are never reported on, the deals are often tiny (between the tens of thousands of dollars and the low hundreds of thousands – generally based on my experience) and the investors are such a mixed lot (ranging from true friends and family to big time brand name venture funds). There is just no way to accurately gather data on this end of the market. As a result, we are all prisoners of our own experience.

My experience (supported by discussions with other lawyers who practice in this space) is that at the low end of this market (true friends and family and tens of thousands of dollars (not hundreds of thousands of dollars)) the investors don’t focus at all on the terms. They do focus on the amount of the discount (but not much even on that simple term). These investors seem simply to be agreeing to convert into the next round no matter what the terms of the next round are. This approach makes sense because the amounts are tiny and should not drive the terms of a "real" round of equity investment. In addition, the investors at this end of the spectrum are often true friends and family. These investors may be less inclined to negotiate than a "professional" investor – especially if they are negotiating with a friend.

At the other end of the spectrum are seed notes from professional venture funds. Many established venture funds make seed investments in the form of notes convertible into a future "A" round. These notes are often for hundreds of thousands (the mode seems to be $250,000). The VCs who provide these notes often team up with another VC (to aggregate up to around $500,000). Most importantly, these investors intend to lead the "A" round, if the business looks promising after some period of time. In these cases, the seed notes typically refer to an attached term sheet for the "A" round. This term sheet is a fully developed term sheet for a Series A investment and sets the terms of the preferred stock into which the note will be converted.

What happens in the space between these two cases (the friends and family investor versus the true VC) – I don’t think there is any reliable data. We are all prisoners of our own experience. My experience is that the more "professional" the investor (and this is particularly true of organized angel/seed funds), would not make equity investment on certain terms. That is to say that there are series A terms upon which they would choose not to invest. The exact nature of the objections may vary from investor to investor. But, having advised many companies with seed investments, I know that these investors care about the terms of their preferred stock. (The VCs obviously care – that is why the actually go to the length of preparing a term sheet.)

I suppose that, to the extent that these investors care, they too could prepare terms sheets (in other words behave more like true VCs). My experience is that they typically do not want to prepare (and negotiate) a term sheet because the cost quickly becomes disproportionate to the amount of the seed investment. VCs are less cost sensitive because they are looking to make a large investment in the "A" round. Also, VCs brook less negotiation over series A terms than angel/seed investors might. As a result they can get to term sheets more efficiently.

All this being said, some seed investors care about the terms of the security into which they will be converted. One way they can address this concern efficiently (without going to the length of creating an equity term sheet) is to include some sort of blocking right in the note itself. That is to say a veto so they will not find themselves converted into a security they would not otherwise invest in. the terms upon which this type of investor is willing to invest are the terms upon which they are willing to invest. If this gives you, as the recipient of the investment, heartburn is something you have to decide.