Putting a valuation on an early-stage company can be difficult, particularly when the company is pre-revenue and still developing its product or technology.  Nevertheless, because most early-stage investment (known as “seed” funding) is in the form of equity, the issue has to be addressed.  The company’s founders and the potential investors then go through an awkward dance where management says the company is worth X and the seed-investors say the company is worth Y (a number you can be sure is much less than X).  The parties will either come to an agreement or they won’t.  The worst situation is where an agreement is reached but one side (almost always the founders) feels that they’ve been taken advantage of.  This can lead to an acrimonious relationship between management and investors and hamstring the company in soliciting future investments.

In some cases, the founders and seed-investors choose to avoid the difficult issue of valuation altogether by agreeing to a convertible debt structure in which the valuation is determined at a future date; such as the first round of financing when valuation is less difficult to fairly determine.  Under this approach (and there are others), the investors receive a convertible promissory note in return for their investment.  The principal and interest on the note then convert to stock based upon the valuation established for the company on the Series A round of financing.  Because the seed investors undertook more risk than the Series A investors, the convertible debt is usually supplemented with so-called “warrant coverage”.  (A “warrant” is a stock option for investors.)  The warrant is usually exercisable for a number of shares of the Series A preferred stock (the number of shares being tied to a percentage of the face amount of the convertible note), on the same terms as the Series A investors, and at a favorable strike price.

–Matt