Raising angel money as debt note or equity?

I'm a VC but was formerly an entrepreneur of 2 companies.

As a founder you're better off raising as convertible debt if (and only if) it doesn't sub-optimize the quality of investors you bring on board. If you're facing the choice of the exact same investor and they'll take either I'd go with convertible debt (unless they're friends & family who you want to be careful not to piss off!).

If you have a better investor who wants to price the round (equity) or a less sophisticated investor who will take convertible debt I'd take the equity.

I discuss the whole topic here --> How to Price Angel Funding

The advantages of a convertible note are that it's a simpler transaction than raising equity. You avoid having to establish a valuation for the company and the legal docs around the convertible note are easier -- so they usually take less time.

Investors often prefer equity rounds as the ultimate price that they pay is usually calculated as a discount on the next round. So, in theory, when they invest in a convertible note, they pay a higher price/valuation as the company grows.

An advantage of the convertible note for the investor is that it's more likely to have value, because if your company is successful either by being profitable or by making its stock valuable, the investor makes money.

This isn't useful to "professional" investors because they're not looking for a reasonable return -- they already have asset classes for that in their personal portfolios which are safer than investing in you. The point is high risk, high return.

But for family and friends like you said, any return is probably welcome.

I suggest doing whatever you have to do to close the financing. Don't over-optimize the financial terms of the deal.

In either case, avoid putting anyone on the board for a seed investment and definitely keep a board majority. In other words, do optimize the control terms of the deal.

If you have the choice, go with capped convertible debt, mostly because the legal docs are cheaper and there are fewer terms to discuss in the term sheet. Although equity is usually easier to understand than caps.

But debt vs. equity really doesn't matter much. Controls matters. Understanding that if you raise money from VCs, you will need their "approval" to raise another round matters.

For an angel round, it's better to raise it as a convertible note since you don't have to value the company nor set a price (as dharmesh suggests). It does depend on the amount raised. If it's 10's of k or maybe a couple 100k, then no big deal. It gets tricker when you raise a lot of money with an angel, say 1M or so. Then it starts to look like more of an A round.

Just to round off the discussions, a few links from people who know far more about this than I do. I used these links to arrive at a structure for my startup.

http://redeye.firstround.com/2006/04/bridge_loans_vs_1.html

Using a convertible note to "jumpstart" your company is a must for a family/friends round. I hate to be the bearer of bad news but many start-ups don't make it and your family and friends are better protected as debtholders in a bankruptcy.

Using a convertible note structure with angels avoids an unnecessary delay in determining what the valuation should be and avoids hard feelings later all around when the price is set in a later equity round with a professional investor based on a beta version of the product or offering and a sound well thought out business plan and sales startegy. One way to protect the noteholder is to provide a sliding scale of discounts to the equity offering price based on the amount of time the note is outstanding i.e. a 95% of the price per share in year one, 90% in year 2 and 85% in year three. There are also ways to give the noteholders a better return through interest accrual and compounding which protect them in the upside scenario.

The key thing is to quickly put together an executive summary, a subscription agreement, a note (and warrant if you need to sweeten the deal) purchase agreement and a convertible note and get it to accredited investors as soon as possible with the expectation that you will close in 4 weeks or less. If it takes longer than that then you need to re-think your proposed market or proposed strategy or you might need to hire a placement agent to get you in front of more investors.

If you want to see what the offering looks like email me (hitechlawyer@gmail.com) and I will forward you a sample.

Good answers here. I generally come down on the side of doing a note. Its simpler and postpones valuation, leaving it to VCs on the follow on round. This is especially useful in today's climate where valuations are slowly recovering. If you can postpone a valuation event, you should.