Gotcha! Convertible notes ARE NOT (literally or figuratively) killing us. Although I did get a nasty papercut reviewing a recent convertible note. In today’s “lawyers knows best” I will tell you why I’m SO OVER convertible notes. If you need a primer on convertible notes, hop on over to my friendly competitor Yokum Taku’s informative website (seriously — its a good read and helpful — I’ll wait).
Ok. Thanks for coming back. Couple reminders about me:
- I spend 85% of my time working with companies
- I spend 15% advising investors and executives
All that really means is I tend be more company/founder favorable on my perspective of the world. And I’d say many lawyers will tell you convertible notes are superior to equity rounds for seed deals. But I simply disagree. I think convertible notes are generally bad for both investors and companies. Couple big reasons for this:
- Confusion on how notes convert — ambiguity can sometimes actually be helpful, but not here. You and your investors should really know exactly what you each own. With notes, you only know kinda what you and your investors own in terms of ownership percentage.
- Even if company and noteholders agree, new investors may ask notes to convert differently. I see this all the time. Your note investors say I agree that the notes absolutely convert this way. New investors comes along and gives you a term sheet and says notes convert a different way. Now you’ve got to go back and sell your note syndicate on why they’re getting something different — even if its only a minor difference.
- Capped notes can cause “phantom preference.” Noteholders generally receive the same preferred stock as the new investors. As a result, they can end up with extra preference. Quick example — lets say the cap on the note equates to a 50% discount. The price per share for the new preferred stock is $1 — so that means the notes convert at $0.50 (with me so far?). Here’s the trick — if my $1M note converts into 2M shares — those shares equate to $2M of preference! That puts your note investors and new investors at odds in certain sale situations. I’ve been there — its not pretty.
I lay all this out (and more) in my premoney conference presentation. And to be fair, there’s lots of fancy lawyering you can do to mitigate some of those risks. To fix those problems and “clarify” other issues means complicating the note docs. And those nuances primarily have lead to creating a whole new financing instrument — the “convertible security.” Meanwhile, good old preferred stock financings have been doing the trick for quite some time. Preferred equity financings solves all this with fewer issues.
“But Josh!” you exclaim in a high pitch whine, “equity scares me!”
- “I don’t want to give up a board seat.” Then don’t. and you don’t have to. Many seed deals are completed without board seats.
- “I don’t want to give investors preference.” Noteholders have preference — you got to pay their money back before you see money in an acquisition typically. Same with Series Seed.
- “They’ll control my company.” Not really. But I’ll admit the form Seriesseed.com docs do have limited contractual veto rights on future financings and sales of the company. But you can ask to remove those in the right context. And remember that noteholders are creditors. So they can come knocking and take over your company in a worst case scenario.
- “It costs too much.” Again, not really. It can cost the same or less than convertible notes. Documentation can be simple.
But, here’s a few points to the contrary:
- No cap: Notes kick ass if you can get away with no cap. IF.
- Small investments: They also help when you’re raising with small amounts of money (under $100K) and with various caps (ed. note — some people go over board with all the caps).
- Psychology: For some reason, investors still think of notes and equity different. I recently did a $3M capped note financing. I gave the founder my spiel on equity. He said — “agree, but if I suggest doing this as equity, those guys will want the full gamut of preferred rights.” In that case, knowing his investors, I agreed with him. So we did the note and it closed. For the life of me, I can’t figure it out but I do know that many investors think very different about a convertible note deal. I see this most often with lawyers fees. I’ve had the same investor invest $500k as a note and then later as equity. That investor forced legal fees on the company for the equity but not the note. Seen that example again and again.
- Options: When you issue options or stock, you typically need to get a valuation. Valuation firms tend to disregard a “cap” when conducting a 409a valuation. That means a much lower post financing employee price for options than the equity round.
- Bridge financing: For a true “bridge” financing, notes are still the best way to go. A “bridge” means you’re raising some money to get you to the next financing. Unlike a seed financing, that usually means you’ve got a few conversations going and the financing is imminent. And the bridge is also typically led by your current investors.
There’s not a black and white answer here BUT I am trending to equity in most angel deals I’m doing — and I’m certainly seeing at least institutional angel investors doing the same. It especially makes sense when its a syndicate of investors that I’m familiar with and can trust. The context of your deal could definitely lead you to a different conclusion. Point being — don’t just default to notes. Talk to your lawyer and advisors about the right structure for you.
