Trends in Angel Seed Financings

Great, current, on-the-ground intelligence re: current trends in seed financing, shared day before yesterday by angel investor Geoff Entress and deal attorney Charles Carter at an LSI seminar in Seattle.

The headline news: convertible notes have returned to Seattle.

After the turn of the century, angels in Seattle implemented their increasingly clear preference for priced rounds. The problem with notes was that the invested company's success ended up punishing the earliest investors. When the note later converted at a high valuation, the note holders were in effect not rewarded for exposing themselves to the earlier, higher risk. The risk could be compensated for, to some extent, by warrants, a conversion discount, or a combination of the two. But pricing seed rounds wholly mitigated the possibility that the company would ride the notes into a future equity round at a huge valuation.

What makes notes more palatable and viable today, Entress explained, are the new norm that notes come with valuation caps. That's a method by which the startup agrees that the note won't be converted at too high a later valuation. In essence, the investor gets the benefit of the conversion at the cap, or the actual price of the later equity round, whichever is lower. If you set the cap where you would have priced an equity seed round anyway, the investor is arguably no worse off accepting a note.

What's happening in Seattle is reflective of a broader trend on the West Coast. Carter cited a Fenwick seed financing survey that reports convertible notes accounted for 41% of seed transactions in 2011, up 10 percentage points from 2010.

But the new norm is in flux.

The caps on seed round notes are rising, driven by the competition for deals in Silicon Valley. Whereas the median cap was $4 million in 2010, it rose to $7.5 million in 2011. In the Valley, Carter said, some deals have no cap at all. To the extent that Seattle startups include California in their fundraising efforts, these trends necessarily impact Seattle angels.

Photo: "caps (some decorated) of graduates at the Unversity of Nebraska - Lincoln" by John Walker / Flickr.