I am not a fan of convertible notes for entrepreneurs for a number of strategic issues. I also understand the reasons why convertible notes have become so popular with entrepreneurs and investors because of the simplicity of the closing. I believe series seed equity can close just as quickly and inexpensively as convertible notes.
For the uninitiated, convertible notes are debt instruments with an implied interest rate, maturity date and a convertible option to shares usually offered with a discount offered to the next pricing round. The intended purpose for investors is to avoid negotiating a valuation with the entrepreneur that might affect the follow- on round negotiated with the next group of investors. For entrepreneurs, convertible debt offers a faster option to close, and ergo cash in hand.
On the other hand, priced rounds offer each investor a price per share. Because of negotiation over valuation they can take longer to develop.
One of my favorite posts on why convertible notes are unfavorable to startups comes from Mark Suster. He offers significant details on the terms of the note and why they are not a good idea for entrepreneurs.
In addition to what Mark has written in detail, my take on this is much more strategic and focused on the alignment of interests between investors and entrepreneurs. First, by placing a maturity date on the convertible note, the entrepreneurs must strategically change their focus from company building to fundraising. Often the maturity date for the convertible note is set for approximately 18 months away. A better date for the entrepreneur would be 24 months, although sometimes they are set as low as 12 months, which is disastrous for the entrepreneur. Given the hunt for funds from new investors, due diligence and the negotiation of valuation—all of this activity can take time away from building and running a company.
The pro convertible funds side of the equation believes that that the time involved on a convertible round is much faster and settles quicker, ergo the whole purpose of a convertible note. My belief is that the function of the convertible note should not be necessary if the interests of the investor and the entrepreneur are strategically aligned.
In early stage companies, the best way to build a startup is through customer development and acquisition. What would an early stage investor prefer? Using their money toward the next fundraising round or focus on customer building? This leads to be an inherent conflict in strategy between the entrepreneur and investor on a convertible round. There is a specific imbedded date to obtain new funds. If that funding is not achieved by that date, the funds become a debt—and entrepreneurs sometimes need a longer runway to launch their companies.
The second issue regarding convertible notes revolves around the purpose of Angel investing. First or second sources of funding after the first formal funding round means to accept the significant risk involved with early stage technology financing. Angels understand that investing at this stage is inherently risky, and the reward is a significant uptick in pricing on subsequent rounds. Convertible notes are an attempt to hedge the risk by not pricing the financing round. Are the protections from down rounds or failures truly built into a note? Yes, a note may be higher in the pecking order of a fire sale in case of a failure. However, if a startup fails, what are the assets truly worth? If the round is not priced, the value cannot be determined easily.
What happens if the entrepreneur does not achieve the steps needed to get the next round of funding? The original Angel has a choice, put in a second round or let the company go broke. However, if the entrepreneur has been able to find another investor, the golden rule applies: “He who has the gold, rules.” The investor leading the next round may decide to offer to fund with the original note holders waiving a number of their protective rights.
Pricing a round allows the Angel to see the negotiating techniques of a founder and the founder to see how helpful an Angel is to the startup. They can begin to see whether their interests are truly aligned. Are both negotiating with the same sense of fairness and aligned interests? Why not have that difficult conversation about pricing, now? It shows the mettle of your CEO. It determines Angel alignment with company goals. If a valuation can’t be agreed upon fairly quickly then perhaps the deal should not have been done at all. Fred Wilson of Union Square Ventures said it well, “Equity is simple and you own what you own.”
As an investor, I attempt to understand the upside risk and prefer a clear valuation. After all, this is my risk capital portfolio. I want my entrepreneur to focus on building the company by creating a sound customer base, so that the next round is a growth round, not another marketing round.
