8 ms·

Bad Notes on Venture Capital

223 points by brentm 12y ago

randylubin 12y ago
It's my impression that everything he says, if true, can also be applied to YC safe. Is that correct? http://www.ycombinator.com/documents/ http://www.ycombinator.com/documents/
- austenallred 12y ago
  Yes. All of that applies to SAFEs as well, which are basically convertible notes that aren't "debt." Basically convertible notes were kind of a financial hack that let you take money without setting a price by calling it "debt," even though no one really regarded it as debt. That brought along a couple small negative side effects, but the good outweighed the bad and let you close rounds quickly without $10-25k in legal fees and seemingly endless negotiation. A SAFE is the same thing, but it jumps through the hoops necessary to not be called "debt" and gets rid of those side effects.
ForHackernews 12y ago
I don't really understand any of this. What are "convertible notes", what's a "cap"? Is there a beginners glossary somewhere?
- peterjancelis 12y ago
  Convertible notes are a way to invest money now (the 'note') at a valuation that will be decided later (at 'conversion'). It is mostly used by angel investors to invest in very young startups for which it is too hard to put a valuation on them. The conversion of the convertible note debt into equity happens at series A investment by venture capitalists. Often the convertible note holders get a discount on the valuation, to compensate for putting in their money earlier. There may also be time limits on the conversion or a cap on the valuation. Example: Angel invests $500K in startup in convertible note form, startup raises 10M from venture capital firm at 90 million pre-money valuation later. The VC firm ends up with 10% of the equity, because 10 million is 10% of 100 million post-money valuation (90m pre + 10m invested). The angel will receive 500K / 100 million = 0.5% of equity if there is no cap or discount. If there is say a 50% discount, the angel gets 500K / 50 million = 1% equity so double the equity. Same effect would be if there is a cap of the conversion valuation at 50 million, i.e. no matter what valuation the VCs invest at the angel gets at least 1% of equity because 500K / 50 million = 1%. Hope it makes sense.
  - btown 12y ago
    This is a great and concise description. So in effect, are the terms on convertible notes just bets on the following round's valuation? In that case, it seems to me that's not much different from valuing the company right now, because if you have enough information (from projections & standard multipliers for the industry/sector) to bet on the A round's valuation, you could just interpolate a valuation at the current time... I'm starting to realize that my gut reaction to squint skeptically at convertible notes wasn't too far off the mark... it's like going to Vegas and betting your company, but everyone else at the poker table has been playing for years longer than you have...
    - peterjancelis 12y ago
      Convertible notes are a way to incentivize great execution by the founder team between the angel round and the series A. Execute better => Higher series A valuation => Less dilution from the convertible debt. At the angel stage there are very little metrics and multiples to go by, hence why you need to invest in the team and incentivize them using convertibles.
  - arethuza 12y ago
    Are convertible notes treated as debt before the conversion happens - i.e. are they liabilities on the balance sheet before then?
    - peterjancelis 12y ago
      Yes, convertibles are a debt instrument and can even have interest payments attached to them.
      - ganeumann 12y ago
        I believe that in the US they have to have interest payments (although these can be deferred for some period of time), otherwise they are not legally considered debt.
- mbesto 12y ago
  As much as I hate TC, these are well written: http://techcrunch.com/2012/04/07/convertible-note-seed-financings/ http://techcrunch.com/2012/04/07/convertible-note-seed-finan... http://techcrunch.com/2012/04/21/convertible-note-seed-financings-econ-101/ http://techcrunch.com/2012/04/21/convertible-note-seed-finan...
- mikeleeorg 12y ago
  Fred Wilson's series "MBA Mondays" is a great place to start: http://avc.com/archive/#mba_mondays_archive http://avc.com/archive/#mba_mondays_archive Start from the bottom and go up (reverse-chronological order). Better yet, save them all into Instapaper or Pocket and read them offline at your leisure. Each article is fairly short yet packed full of info.
joshu 12y ago
So here's how the preference multiplier happens: when the company raises an equity round, you calculate the new share price, and the noteholders are assigned the investment's worth of shares. However, because of the change in value, they would get more preferred shares per dollar invested than the new investors. So generally you get just the original price's worth of preferred and the rest is common.
jacquesm 12y ago
Super good piece, required reading for anybody currently founder or co-founder of a start-up and considering convertible notes.
AndriusWSR 12y ago
Any more good pieces regarding this topic? Super interesting!
- jacquesm 12y ago
  http://www.startupcompanylawyer.com/2011/01/09/is-convertible-debt-with-a-price-cap-really-the-best-financing-structure/ http://www.startupcompanylawyer.com/2011/01/09/is-convertibl...
rahooligan 12y ago
according to this the main problem with notes is a down round can get you into a lot of trouble because of the liquidation preference multiplier. but what if you never have a down round? if you can avoid the down round, it seems like convertible notes are still preferable. down rounds are bad even with priced seed rounds.
- tptacek 12y ago
  Just having the dynamic of "down rounds" harms some of the value proposition of convertible note seed funds --- the C.W. behind them suggests that you can use them to raise casually, without freaking out about company valuation. But if they create a signaling problem for an A round, operators need to be just as careful with pricing the notes as they would with their A round, and A round pricing is arduous.
- joshu 12y ago
  The liquidation preference multiplier has to do with when noteholder gets preferred only instead of preferred + common on rounds that are a higher valuation than their cap.
  - rahooligan 12y ago
    According to Mark Suster's earlier article - http://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/ http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou..., there are 2 main downsides to convertible notes from a founder's point of view: 1) If an investor invests $500k at a $4.5MM cap, he signs up to get 10% of the company assuming the Series A priced round will be at a higher valuation. But, if Series A is at a lower valuation, say $2.5MM, then the investor gets 20% of the company. However, if there was a discount associated with the convertible note then the note converts at 80% of $2.5MM. So a down round is really bad for the founder. But I can't imagine a down round being much better for a priced round. 2) If the Series A is $3MM at $12MM pre with 1x liquidation preference, the Series A investor gets 20% of the company. The seed investor who invested $500k will have his shares converted at the $5MM valuation. However, he will end up with a 3x liquidation preference or $1.5MM in liquidation preferences. I think this is okay as long as you raise a few hundred thousand dollar convertible note seed round. If the convertible note seed round ends up to be in the $1MM range I think this can become an issue for the Series A investor which is Suster's main point. Convertible notes have benefits like high resolution financing, less control & no board seats. I still think convertible notes are the way to go if you are raising a few hundred thousand dollars in seed. But if you raising a seed in the $1MM range, it seems like priced rounds are preferred.
tptacek 12y ago
The second vignette in this article has Suster suggesting that convertible notes carry liquidation preferences and anti-dilution. Does he mean that some subtle property of convertible notes create those terms in practice, or does he literally mean that if you read the note paperwork you'll find a 2x liquidation preference and a full ratchet?
- deleted 12y ago
  [deleted]
- brl 12y ago
  Check out the 'more details on Convertible Notes' link for the answer to your question.
  - tptacek 12y ago
    Thanks, you're right, that's a really useful link. (http://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/ http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou...)
- joshu 12y ago
  liquidation pref: a subtle property of conversion (if you buy preferred only at the cap price instead of effective price you are effectively getting >1x your preference by ending up with more shares.) anti-dilution: only if negotiated
  - tptacek 12y ago
    My current impression is that the "full ratchet" he's referring to is conceptually just the deferred valuation itself.
AVTizzle 12y ago
Posts like this make me realize how amateur and inexperienced I am. Seriously. I've taken it for granted for the past 3 years now that convertible notes were universally regarded as the best and smartest form of fundraising for seed rounds, just based on what I've found and read in various places online (lots of it here on HN, for that matter...) And here we have Suster laying out clearly the opposite side of the argument in a way that humbles me. This is clearly an area that I have a lot to learn from people much smarter than I. Most YC companies go on to raise rounds using YC's SAFE, which is an adaptation of convertible notes, right? If so, I'd love to hear a YC partner (or partners) address these points.
- not_that_noob 12y ago
  Everything has its pros and cons, and he's pointing out that if you have a note with a high cap and then can't raise the next round above the cap, or if you have multiple notes outstanding, then it might mess with the mathematics of the cap table in a bad way when you raise a priced round. The truth is that notes and YC's SAFE are still the way to go. Why? If the startup is taking off, then you're going to blow past your cap (which you should set fairly) and everyone's happy. If the startup isn't headed anywhere, well, why the hell are you raising more anyway? Consider selling or shutting it down. The problems he's pointing out apply in this case, and frankly you can always in such a situation consider re-negotiating prior deals if you have to. In other words, these are theoretical objections at best. Most 'traditional' investors used to have it good in the (good, according to them) old days. They had the leverage, so they forced terms that were good for them. This meant lower valuations in general compared to today, and control in the form of board seats, which you generally had to have once you had different classes of equity. Those days are long gone, and this strikes me as a lament for the way things used to be.
  - joshu 12y ago
    I've done about 90 angel investments. The average return for companies that start as a cap and not equity is < 1. Companies that have sufficient success at the time of raise do not generally do debt. YC biases them more towards notes, though.
patio11 12y ago
Is there an entrepreneur willing to say "Yep, tried them, got bitten in the hindquarters", even anonymously? I don't necessarily disbelieve here but it strikes me that VCs have the curious property of always giving fundraising advice which is in the interest of VCs. I acknowledge that somewhere in this wide world there may actually be a VC motivated primarily by friends-and-family getting appropriate compensation for risky investments but that is not the way I will bet. My understanding -- limited, in that I've been a party to two but from the other side of the table -- is that a major reason they became popular is because they take the fangs out of collusive behavior by investors. The Valley had evolved a "Well, I'll invest if you get a lead" "Well, I'll lead if you close $X" system which froze out a lot of companies if the founders didn't have deep, pre-existing social networks. "You want a lead!" sounds a lot like wistful nostalgia for this gatekeeping behavior. I understand why a gatekeeper would see it that way. I don't understand why the gated would.
- joshu 12y ago
  It's better for noteholders for the conversion price to be as low as possible. I'm sure this creates bad behavior. I've certainly felt badly about deals that went against me, though I haven't done anything.
- csbrooks 12y ago
  Congrats on 100,000 karma, btw. O_o
  - patio11 12y ago
    Thanks. Man, inside Valley baseball, wouldn't have guessed that would be the cause 6 years ago.
- gyardley 12y ago
  Not exactly what you're asking for, but I did a priced first round because my investors insisted on it and believe it helped me a great deal more than a convertible note would've. In particular, what Suster says about the importance of having a lead rings absolutely true to me. My investors were a huge help when figuring out a complicated merger that eventually led to a terrific outcome. If I had raised from a big bunch of smaller, not-particularly-invested angels instead - well, who's to say, but I suspect I would've botched it.
Brushfire 12y ago
The benefit of convertible notes / SAFE's is that you get the invested cash IMMEDIATELY. This is a non-trivial benefit for most startups. When raising a full round of capital, say 1M, you don't get any of it until you 'close', after everyone is committed. Convertible notes allow entrepreneurs to build progressively towards a close, without waiting for all the cash to come in -- which might come too late. So, sure, if you're flush with cash, then convertible notes are a worse idea relative to a priced round. But when is that ever the case when fundraising?
- bjt 12y ago
  The article's discussion of 90 day "top up" terms seems to address that.
  - Brushfire 12y ago
    Yeah, but it still isnt the same -- because for the first investor, you still have to get them to agree to pony up the full 500k. When dealing with smaller angels, its easier to get your first 250k - 500k in 50k-100k increments. I do like the idea of setting a price instead of a cap. Even if it means your price is a bit lower than the cap, it should be relatively straightforward to transition from a cap to a price with sophisticated investors, and it protects you in any weird situation.
    - ganeumann 12y ago
      You can certainly do smaller increments with an equity round. But because equity rounds tend to have leads and the lead is usually the biggest check, they also tend to have most of the money committed at first close. Many note investors also ask that a certain amount be committed before the first close.
mmphosis 12y ago
VC wants to make money. VC wants to make money off of your work/startup/company. VC makes money using the given terms. When it comes right down to it. The money they "give" is not given. It is a loan with terms and conditions. You need to be aware of this. You need to know what a loan is. It is money you are borrowing that you must pay back WITH INTEREST. Find out how much interest that is. "It’s like we need a finance 101 course for entrepreneurs" Debt money is bad. I realize a lot of people will tell you that this is how the world runs, or this how they run their business, or I got successful in business taking out a big loan, etc and so on. Like the gambler, they don't tell you about all the losses. Save your money. Keep your work/startup/company. http://www.gamesradar.com/nintendo-doomed-not-likely-just-take-look-how-much-money-its-got-bank/ http://www.gamesradar.com/nintendo-doomed-not-likely-just-ta... I've read that Microsoft has always had enough money in the bank to operate for a full year without making any money.
- serve_yay 12y ago
  It is just impossibly more complicated than this. Financing a company with venture capital is no time to break out the folksy wisdom. "Well, it's just a loan with interest". Good lord, no.
- jacquesm 12y ago
  VCs are not the driving force behind convertible notes, entrepreneurs usually are (and for good reasons). Yes, VCs like to make money, they'd even like to make it of your work/startup/company but the odds are such that they likely will not. So they will invest in a company for equity rather than as a loan that carries interest and that you can pay back at your leisure, unless it is really early days and so very hard to assign a value to the company (not that that is much easier later on). I Really do agree that we probably need a finance 101 for entrepreneurs, and you probably should enroll. Debt is not necessarily bad, giving out a chunk of equity in return for funds is not necessarily bad. No more than a hammer or an axe are bad.
grellas 12y ago
With seed funding, founders need to accomplish several goals: (1) raise early money as a bridge to Series A to avoid having to take large money right up front when valuation is at its lowest and the dilutive hit will be at its maximum; (2) keep equity incentives priced relatively low so that a quality team can be assembled without giving its members tax grief; (3) keep transaction costs in raising the money reasonable; (4) move to close relatively quickly to avoid getting sucked into the fundraising time sink. Convertible notes and convertible equity (SAFEs) both allow founders to meet these goals in ways that equity rounds simply do not. In this sense, they have incredible value as tools to be used by an early-stage startup. Are they perfect tools? Well, no. Each has its own limitations and problems and each can be abused on either the company side or the investor side. Founders routinely used to take uncapped convertible notes, build value, stretch out the process, and leave the investors getting ever-diminishing rewards all the while that their money was being used to build that value. Investors wised up and began insisting on caps to avoid such abuses. They wanted to protect the idea that they would get significant extra rewards for taking the earliest-stage risk. It was not enough, e.g., to get a 20% price discount at Series A if you convert at $20M pre-money valuation when the company was probably worth no more than, e.g., $5M at the time you invested the seed money. The investor insisted on locking in that ceiling on valuation as a means of self-protection. Does this result in occasional windfalls to bridge investors who take capped notes (or SAFEs)? Yes, it does. Does this arrangement have attributes of something that resembles a liquidation preference in its functioning? Well, yes, it does. Ditto for the full-ratchet anti-dilution attributes. These things are very real attributes that do affect the value of using these tools for founders and their companies. They add to the negative side of the ledger. But let us say that your startup had to give four times the value in Series A preferred stock relative to other investors to the hypothetical investor noted above ($20M valuation, $5M cap). What does this mean? If that early investor put in $300K and the Series A round was for $7.5M, the early investor might have gotten a windfall but the impact on the round is small because the dollars involved are not large. And if the venture did not do well and the Series A round priced at $3M, then that same investor would still get something like a 20% discount off the lower valuation instead of having had to peg his fortunes to the $5M value used for the cap as he would have had to do had he taken equity. But so what? The dollars are still small and it doesn't matter relative to the value and utility offered by using the convertible note (or SAFE) tool. And, for every "windfall" gained by such investors, you have all sorts of cases where the failure rate is particularly high because of the extreme risks existing at the earliest stages before it is even determined that a company is truly "fundable." The value of notes and SAFEs is flexibility. Your occasional investor will get special advantages but these are not unduly costly to you as a company. And you have a good measure of control over how you do things. Your first note can be capped but, as you gain traction, later notes can be uncapped. You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing. You can do the number of notes and in the amounts you immediately need. You don't have to go through endless negotiations over the sorts of things that can accompany an equity round (especially protective provisions and similar restrictions on what a company can do). You avoid giving your new investors a veto right or other significant say on what you can do in future rounds, as you would normally have to do if you did an early-stage equity round using preferred stock. Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round. And, in most cases, it is a useful and valuable dynamic for founders and their companies notwithstanding the trade-offs. In this sense, the main idea of this piece that I would strongly disagree with is its suggestion that using convertible notes is somehow a sucker deal. It can be if done wrong but it most often is just the opposite. Another metric for measuring the relative value of these tools is to see who is using them. Convertible notes have had massive and widely dispersed use now for many years. The most sophisticated investors have had no problem with them in general, and that includes the VCs who lead Series A rounds in which converting noteholders get the benefits of their caps and take more relative value in the round than the VCs themselves do. As with anything else in the startup world, founders need to use good judgment. The points made in this piece are informed and technically accurate. And they do underscore some clear disadvantages in using notes/SAFEs. My point is that, notwithstanding these defects, notes/SAFEs retain great utility for founders in the context of the broader issues they need to address (minimizing tax risks, keeping stock price low, keeping transaction costs down, etc.). And so this is a good piece to add to your knowledge base but it should not deter you from using non-equity forms of seed funding as long as use of these tools meets your bigger goals. You have control at that stage. Use that control wisely.
api 12y ago
Check my understanding? So convertible debt isn't really debt-- it's an equity investment with deferred closing and terms. Right? I can see then how this can lead to bad outcomes for the entrepreneur (behaves like a full ratchet if there's a cap) or bad outcomes for the investor (you've deferred the conversation and agreement on expectations). But at the same time it is in some ways simpler, and you get the cash immediately. Right? Hmm... this is interesting. He suggests setting a price. So let's say I want to raise convertible debt... he's suggesting that one instead says "I'm raising one million at X" and sell convertible notes with a fixed price instead of a cap? What would that look like?
taytus 12y ago
Only morons start a business on a loan - Mark Cuban https://www.youtube.com/watch?v=KYneLGRTgy8 https://www.youtube.com/watch?v=KYneLGRTgy8
notastartup 12y ago
does this mean that the founders in that story accept money based on the agreeement that whatever the VC thinks their stake is is what will be the valuation? I'm a little fuzzy on how this works.
abalone 12y ago
Here's the thing that's left out of this investor-friendly analysis, and why Suster is wrong about the "irrationality" of no-cap deals: For smaller angels, access to the deal itself is valuable. Small investors don't have access to Series A. That's why the analogy with the stock market is broken: "Can you imagine investing in the stock market where your price was determined at a future date and the better that company performed the HIGHER the price you paid for that investment." The reality is angels don't have the option of purchasing the stock after the seed round. So, it can make perfect economic sense for an angel to pay a premium to get access to a deal. And if that premium comes in the form of pre-paying for a chunk of the Series A (one way to look at a no-cap deal), that can make sense -- perhaps even more sense that an enhanced seed valuation would. A discount would be sweetener on top of that. But to be clear: there is a rational case for smaller investors taking no-cap deals in order to get a chunk of the next Facebook, which they otherwise wouldn't be able to get. Seed rounds present a unique intersection point for founders & smaller angels where their interests overlap. I think the bigger-sized investor community are somewhat threatened by that, and that's why we're seeing such a sophisticated campaign against no-cap convertible notes. But the climate is now competitive enough and small-angel platforms are getting enough traction that you can sense their anxiety that no-caps may be coming back, to the great benefit of founders.
- jacquesm 12y ago
  That is an extremely interesting point. I never thought of it that way, seeing series 'A' with some regularity and being a (consulting) participant in the deals I never felt the urge to invest in these deals simply because that would create a conflict of interest. But the fact that the only investments that I did do were as an angel in 3 different companies was simply due to the fact that the rounds were very early and the amounts were still low enough that they were in my 'bracket' or 'comfort zone'. I guess if I felt the need or desire to participate in series 'A' I would join an established VC as a limited partner. One of the reasons VCs would not like to have a bunch of angel investors join in a series A is that there would likely spontaneously combust into existence a sort of Polish Parliament and then the deal would likely fall through. Syndicated deals have some of these aspects already, especially if the geographic and/or cultural spread of VCs is large.
vasilipupkin 12y ago
How often do companies that end up doing a round below the original cap ( effectively a down round ) actually recover and do well? Does this really matter? Seems like it is such a big risk to investors to invest below the cap that they should be appropriately compensated for it, which is what the discount accomplishes
sandGorgon 12y ago
Does anyone have a valuation model spreadsheet that accounts for multiple rounds of convertible note financing, and purposed towards a Series A conversation ? As a founder, I have tried searching for these but never managed to find one. I'm not sure if it is an India thing, where investors actively discourage convertible notes because of the availability of several pounds of equity flesh in exchange for angel stage funding.
lightedstar 12y ago
Why don't convertible notes in the friends in family scenario just set a multiple that will be suitable in the case equity is diluted? In this case it seems the main interest in supporting an entrepreneur they believe in and getting their money back - ideally at a better return than they'd get elsewhere. For example, would a 2x return on a convertible note pose any real problem to investors in subsequent rounds? Glad to see so much discussion about it. After taking Venture Deals with Brad Feld and Jason Mendelson through Kauffman Fellows Academy / Novoed, I'm quite curious about trends on this topic.
lightedstar 12y ago
Why don't convertible notes in the friends in family scenario just set a multiple that will be suitable in the case equity is diluted? In this case it seems the main interest in supporting an entrepreneur they believe in and getting their money back - ideally at a better return than they'd get elsewhere. For example, would a 2x return on a convertible note pose any real problem to investors in subsequent rounds? Glad to see so much discussion about it. After taking Venture Deals with Brad Feld and Jason Mendelson through Kauffman Fellows Academy / Novoed, I'm quite curious about trends on this topic.
jsun 12y ago
Wow. this is misleading. Convertible notes are the best things to happen to startup founders in the history of fundraising. Take a modern convertible note to an angel investor from the pre-bubble 90's and they'd laugh you out of whatever coffee shop you happen to be sitting in. All of the "examples" shown in the blog post make irrational arguments. Show me one scenario (in numbers) where using a convertible note for a seed round was suboptimal compared to an obtainable equity deal. If I didn't know better I'd think this was an example of a VC trying to smear an awesome instrument so hopefully they won't have to compete with investors willing to write them.
tsunamifury 12y ago
All of this is a distraction game played by VC's to avoid the real point of entrepreneurship. Make a product worth something to a target market. Sell it or get enough traction. Find a company who would like to buy you or go public based on your growth. All this other stuff is a distraction created to keep you from focusing on what you are here for. To build great things and sell it for profit. Otherwise... whats the point. The best negotiating term is having a great product. You won't raise your way to a product/market fit.

223 points by brentm 12y ago

It's my impression that everything he says, if true, can also be applied to YC safe. Is that correct? http://www.ycombinator.com/documents/ http://www.ycombinator.com/documents/

austenallred 12y ago
Yes. All of that applies to SAFEs as well, which are basically convertible notes that aren't "debt." Basically convertible notes were kind of a financial hack that let you take money without setting a price by calling it "debt," even though no one really regarded it as debt. That brought along a couple small negative side effects, but the good outweighed the bad and let you close rounds quickly without $10-25k in legal fees and seemingly endless negotiation. A SAFE is the same thing, but it jumps through the hoops necessary to not be called "debt" and gets rid of those side effects.

ForHackernews 12y ago

I don't really understand any of this. What are "convertible notes", what's a "cap"? Is there a beginners glossary somewhere?

peterjancelis 12y ago
Convertible notes are a way to invest money now (the 'note') at a valuation that will be decided later (at 'conversion'). It is mostly used by angel investors to invest in very young startups for which it is too hard to put a valuation on them. The conversion of the convertible note debt into equity happens at series A investment by venture capitalists. Often the convertible note holders get a discount on the valuation, to compensate for putting in their money earlier. There may also be time limits on the conversion or a cap on the valuation. Example: Angel invests $500K in startup in convertible note form, startup raises 10M from venture capital firm at 90 million pre-money valuation later. The VC firm ends up with 10% of the equity, because 10 million is 10% of 100 million post-money valuation (90m pre + 10m invested). The angel will receive 500K / 100 million = 0.5% of equity if there is no cap or discount. If there is say a 50% discount, the angel gets 500K / 50 million = 1% equity so double the equity. Same effect would be if there is a cap of the conversion valuation at 50 million, i.e. no matter what valuation the VCs invest at the angel gets at least 1% of equity because 500K / 50 million = 1%. Hope it makes sense.
- btown 12y ago
  This is a great and concise description. So in effect, are the terms on convertible notes just bets on the following round's valuation? In that case, it seems to me that's not much different from valuing the company right now, because if you have enough information (from projections & standard multipliers for the industry/sector) to bet on the A round's valuation, you could just interpolate a valuation at the current time... I'm starting to realize that my gut reaction to squint skeptically at convertible notes wasn't too far off the mark... it's like going to Vegas and betting your company, but everyone else at the poker table has been playing for years longer than you have...
  - peterjancelis 12y ago
    Convertible notes are a way to incentivize great execution by the founder team between the angel round and the series A. Execute better => Higher series A valuation => Less dilution from the convertible debt. At the angel stage there are very little metrics and multiples to go by, hence why you need to invest in the team and incentivize them using convertibles.
- arethuza 12y ago
  Are convertible notes treated as debt before the conversion happens - i.e. are they liabilities on the balance sheet before then?
  - peterjancelis 12y ago
    Yes, convertibles are a debt instrument and can even have interest payments attached to them.
    - ganeumann 12y ago
      I believe that in the US they have to have interest payments (although these can be deferred for some period of time), otherwise they are not legally considered debt.
mbesto 12y ago
As much as I hate TC, these are well written: http://techcrunch.com/2012/04/07/convertible-note-seed-financings/ http://techcrunch.com/2012/04/07/convertible-note-seed-finan... http://techcrunch.com/2012/04/21/convertible-note-seed-financings-econ-101/ http://techcrunch.com/2012/04/21/convertible-note-seed-finan...
mikeleeorg 12y ago
Fred Wilson's series "MBA Mondays" is a great place to start: http://avc.com/archive/#mba_mondays_archive http://avc.com/archive/#mba_mondays_archive Start from the bottom and go up (reverse-chronological order). Better yet, save them all into Instapaper or Pocket and read them offline at your leisure. Each article is fairly short yet packed full of info.

joshu 12y ago

So here's how the preference multiplier happens: when the company raises an equity round, you calculate the new share price, and the noteholders are assigned the investment's worth of shares. However, because of the change in value, they would get more preferred shares per dollar invested than the new investors. So generally you get just the original price's worth of preferred and the rest is common.

jacquesm 12y ago

Super good piece, required reading for anybody currently founder or co-founder of a start-up and considering convertible notes.

AndriusWSR 12y ago

Any more good pieces regarding this topic? Super interesting!

jacquesm 12y ago
http://www.startupcompanylawyer.com/2011/01/09/is-convertible-debt-with-a-price-cap-really-the-best-financing-structure/ http://www.startupcompanylawyer.com/2011/01/09/is-convertibl...

rahooligan 12y ago

according to this the main problem with notes is a down round can get you into a lot of trouble because of the liquidation preference multiplier. but what if you never have a down round? if you can avoid the down round, it seems like convertible notes are still preferable. down rounds are bad even with priced seed rounds.

tptacek 12y ago
Just having the dynamic of "down rounds" harms some of the value proposition of convertible note seed funds --- the C.W. behind them suggests that you can use them to raise casually, without freaking out about company valuation. But if they create a signaling problem for an A round, operators need to be just as careful with pricing the notes as they would with their A round, and A round pricing is arduous.
joshu 12y ago
The liquidation preference multiplier has to do with when noteholder gets preferred only instead of preferred + common on rounds that are a higher valuation than their cap.
- rahooligan 12y ago
  According to Mark Suster's earlier article - http://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/ http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou..., there are 2 main downsides to convertible notes from a founder's point of view: 1) If an investor invests $500k at a $4.5MM cap, he signs up to get 10% of the company assuming the Series A priced round will be at a higher valuation. But, if Series A is at a lower valuation, say $2.5MM, then the investor gets 20% of the company. However, if there was a discount associated with the convertible note then the note converts at 80% of $2.5MM. So a down round is really bad for the founder. But I can't imagine a down round being much better for a priced round. 2) If the Series A is $3MM at $12MM pre with 1x liquidation preference, the Series A investor gets 20% of the company. The seed investor who invested $500k will have his shares converted at the $5MM valuation. However, he will end up with a 3x liquidation preference or $1.5MM in liquidation preferences. I think this is okay as long as you raise a few hundred thousand dollar convertible note seed round. If the convertible note seed round ends up to be in the $1MM range I think this can become an issue for the Series A investor which is Suster's main point. Convertible notes have benefits like high resolution financing, less control & no board seats. I still think convertible notes are the way to go if you are raising a few hundred thousand dollars in seed. But if you raising a seed in the $1MM range, it seems like priced rounds are preferred.

tptacek 12y ago

The second vignette in this article has Suster suggesting that convertible notes carry liquidation preferences and anti-dilution. Does he mean that some subtle property of convertible notes create those terms in practice, or does he literally mean that if you read the note paperwork you'll find a 2x liquidation preference and a full ratchet?

deleted 12y ago
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brl 12y ago
Check out the 'more details on Convertible Notes' link for the answer to your question.
- tptacek 12y ago
  Thanks, you're right, that's a really useful link. (http://www.bothsidesofthetable.com/2012/09/05/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didnt-understand/ http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou...)
joshu 12y ago
liquidation pref: a subtle property of conversion (if you buy preferred only at the cap price instead of effective price you are effectively getting >1x your preference by ending up with more shares.) anti-dilution: only if negotiated
- tptacek 12y ago
  My current impression is that the "full ratchet" he's referring to is conceptually just the deferred valuation itself.

AVTizzle 12y ago

Posts like this make me realize how amateur and inexperienced I am. Seriously. I've taken it for granted for the past 3 years now that convertible notes were universally regarded as the best and smartest form of fundraising for seed rounds, just based on what I've found and read in various places online (lots of it here on HN, for that matter...) And here we have Suster laying out clearly the opposite side of the argument in a way that humbles me. This is clearly an area that I have a lot to learn from people much smarter than I. Most YC companies go on to raise rounds using YC's SAFE, which is an adaptation of convertible notes, right? If so, I'd love to hear a YC partner (or partners) address these points.

not_that_noob 12y ago
Everything has its pros and cons, and he's pointing out that if you have a note with a high cap and then can't raise the next round above the cap, or if you have multiple notes outstanding, then it might mess with the mathematics of the cap table in a bad way when you raise a priced round. The truth is that notes and YC's SAFE are still the way to go. Why? If the startup is taking off, then you're going to blow past your cap (which you should set fairly) and everyone's happy. If the startup isn't headed anywhere, well, why the hell are you raising more anyway? Consider selling or shutting it down. The problems he's pointing out apply in this case, and frankly you can always in such a situation consider re-negotiating prior deals if you have to. In other words, these are theoretical objections at best. Most 'traditional' investors used to have it good in the (good, according to them) old days. They had the leverage, so they forced terms that were good for them. This meant lower valuations in general compared to today, and control in the form of board seats, which you generally had to have once you had different classes of equity. Those days are long gone, and this strikes me as a lament for the way things used to be.
- joshu 12y ago
  I've done about 90 angel investments. The average return for companies that start as a cap and not equity is < 1. Companies that have sufficient success at the time of raise do not generally do debt. YC biases them more towards notes, though.

patio11 12y ago

Is there an entrepreneur willing to say "Yep, tried them, got bitten in the hindquarters", even anonymously? I don't necessarily disbelieve here but it strikes me that VCs have the curious property of always giving fundraising advice which is in the interest of VCs. I acknowledge that somewhere in this wide world there may actually be a VC motivated primarily by friends-and-family getting appropriate compensation for risky investments but that is not the way I will bet. My understanding -- limited, in that I've been a party to two but from the other side of the table -- is that a major reason they became popular is because they take the fangs out of collusive behavior by investors. The Valley had evolved a "Well, I'll invest if you get a lead" "Well, I'll lead if you close $X" system which froze out a lot of companies if the founders didn't have deep, pre-existing social networks. "You want a lead!" sounds a lot like wistful nostalgia for this gatekeeping behavior. I understand why a gatekeeper would see it that way. I don't understand why the gated would.

joshu 12y ago
It's better for noteholders for the conversion price to be as low as possible. I'm sure this creates bad behavior. I've certainly felt badly about deals that went against me, though I haven't done anything.
csbrooks 12y ago
Congrats on 100,000 karma, btw. O_o
- patio11 12y ago
  Thanks. Man, inside Valley baseball, wouldn't have guessed that would be the cause 6 years ago.
gyardley 12y ago
Not exactly what you're asking for, but I did a priced first round because my investors insisted on it and believe it helped me a great deal more than a convertible note would've. In particular, what Suster says about the importance of having a lead rings absolutely true to me. My investors were a huge help when figuring out a complicated merger that eventually led to a terrific outcome. If I had raised from a big bunch of smaller, not-particularly-invested angels instead - well, who's to say, but I suspect I would've botched it.

Brushfire 12y ago

The benefit of convertible notes / SAFE's is that you get the invested cash IMMEDIATELY. This is a non-trivial benefit for most startups. When raising a full round of capital, say 1M, you don't get any of it until you 'close', after everyone is committed. Convertible notes allow entrepreneurs to build progressively towards a close, without waiting for all the cash to come in -- which might come too late. So, sure, if you're flush with cash, then convertible notes are a worse idea relative to a priced round. But when is that ever the case when fundraising?

bjt 12y ago
The article's discussion of 90 day "top up" terms seems to address that.
- Brushfire 12y ago
  Yeah, but it still isnt the same -- because for the first investor, you still have to get them to agree to pony up the full 500k. When dealing with smaller angels, its easier to get your first 250k - 500k in 50k-100k increments. I do like the idea of setting a price instead of a cap. Even if it means your price is a bit lower than the cap, it should be relatively straightforward to transition from a cap to a price with sophisticated investors, and it protects you in any weird situation.
  - ganeumann 12y ago
    You can certainly do smaller increments with an equity round. But because equity rounds tend to have leads and the lead is usually the biggest check, they also tend to have most of the money committed at first close. Many note investors also ask that a certain amount be committed before the first close.

mmphosis 12y ago

VC wants to make money. VC wants to make money off of your work/startup/company. VC makes money using the given terms. When it comes right down to it. The money they "give" is not given. It is a loan with terms and conditions. You need to be aware of this. You need to know what a loan is. It is money you are borrowing that you must pay back WITH INTEREST. Find out how much interest that is. "It’s like we need a finance 101 course for entrepreneurs" Debt money is bad. I realize a lot of people will tell you that this is how the world runs, or this how they run their business, or I got successful in business taking out a big loan, etc and so on. Like the gambler, they don't tell you about all the losses. Save your money. Keep your work/startup/company. http://www.gamesradar.com/nintendo-doomed-not-likely-just-take-look-how-much-money-its-got-bank/ http://www.gamesradar.com/nintendo-doomed-not-likely-just-ta... I've read that Microsoft has always had enough money in the bank to operate for a full year without making any money.

serve_yay 12y ago
It is just impossibly more complicated than this. Financing a company with venture capital is no time to break out the folksy wisdom. "Well, it's just a loan with interest". Good lord, no.
jacquesm 12y ago
VCs are not the driving force behind convertible notes, entrepreneurs usually are (and for good reasons). Yes, VCs like to make money, they'd even like to make it of your work/startup/company but the odds are such that they likely will not. So they will invest in a company for equity rather than as a loan that carries interest and that you can pay back at your leisure, unless it is really early days and so very hard to assign a value to the company (not that that is much easier later on). I Really do agree that we probably need a finance 101 for entrepreneurs, and you probably should enroll. Debt is not necessarily bad, giving out a chunk of equity in return for funds is not necessarily bad. No more than a hammer or an axe are bad.

grellas 12y ago

With seed funding, founders need to accomplish several goals: (1) raise early money as a bridge to Series A to avoid having to take large money right up front when valuation is at its lowest and the dilutive hit will be at its maximum; (2) keep equity incentives priced relatively low so that a quality team can be assembled without giving its members tax grief; (3) keep transaction costs in raising the money reasonable; (4) move to close relatively quickly to avoid getting sucked into the fundraising time sink. Convertible notes and convertible equity (SAFEs) both allow founders to meet these goals in ways that equity rounds simply do not. In this sense, they have incredible value as tools to be used by an early-stage startup. Are they perfect tools? Well, no. Each has its own limitations and problems and each can be abused on either the company side or the investor side. Founders routinely used to take uncapped convertible notes, build value, stretch out the process, and leave the investors getting ever-diminishing rewards all the while that their money was being used to build that value. Investors wised up and began insisting on caps to avoid such abuses. They wanted to protect the idea that they would get significant extra rewards for taking the earliest-stage risk. It was not enough, e.g., to get a 20% price discount at Series A if you convert at $20M pre-money valuation when the company was probably worth no more than, e.g., $5M at the time you invested the seed money. The investor insisted on locking in that ceiling on valuation as a means of self-protection. Does this result in occasional windfalls to bridge investors who take capped notes (or SAFEs)? Yes, it does. Does this arrangement have attributes of something that resembles a liquidation preference in its functioning? Well, yes, it does. Ditto for the full-ratchet anti-dilution attributes. These things are very real attributes that do affect the value of using these tools for founders and their companies. They add to the negative side of the ledger. But let us say that your startup had to give four times the value in Series A preferred stock relative to other investors to the hypothetical investor noted above ($20M valuation, $5M cap). What does this mean? If that early investor put in $300K and the Series A round was for $7.5M, the early investor might have gotten a windfall but the impact on the round is small because the dollars involved are not large. And if the venture did not do well and the Series A round priced at $3M, then that same investor would still get something like a 20% discount off the lower valuation instead of having had to peg his fortunes to the $5M value used for the cap as he would have had to do had he taken equity. But so what? The dollars are still small and it doesn't matter relative to the value and utility offered by using the convertible note (or SAFE) tool. And, for every "windfall" gained by such investors, you have all sorts of cases where the failure rate is particularly high because of the extreme risks existing at the earliest stages before it is even determined that a company is truly "fundable." The value of notes and SAFEs is flexibility. Your occasional investor will get special advantages but these are not unduly costly to you as a company. And you have a good measure of control over how you do things. Your first note can be capped but, as you gain traction, later notes can be uncapped. You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing. You can do the number of notes and in the amounts you immediately need. You don't have to go through endless negotiations over the sorts of things that can accompany an equity round (especially protective provisions and similar restrictions on what a company can do). You avoid giving your new investors a veto right or other significant say on what you can do in future rounds, as you would normally have to do if you did an early-stage equity round using preferred stock. Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round. And, in most cases, it is a useful and valuable dynamic for founders and their companies notwithstanding the trade-offs. In this sense, the main idea of this piece that I would strongly disagree with is its suggestion that using convertible notes is somehow a sucker deal. It can be if done wrong but it most often is just the opposite. Another metric for measuring the relative value of these tools is to see who is using them. Convertible notes have had massive and widely dispersed use now for many years. The most sophisticated investors have had no problem with them in general, and that includes the VCs who lead Series A rounds in which converting noteholders get the benefits of their caps and take more relative value in the round than the VCs themselves do. As with anything else in the startup world, founders need to use good judgment. The points made in this piece are informed and technically accurate. And they do underscore some clear disadvantages in using notes/SAFEs. My point is that, notwithstanding these defects, notes/SAFEs retain great utility for founders in the context of the broader issues they need to address (minimizing tax risks, keeping stock price low, keeping transaction costs down, etc.). And so this is a good piece to add to your knowledge base but it should not deter you from using non-equity forms of seed funding as long as use of these tools meets your bigger goals. You have control at that stage. Use that control wisely.

api 12y ago

Check my understanding? So convertible debt isn't really debt-- it's an equity investment with deferred closing and terms. Right? I can see then how this can lead to bad outcomes for the entrepreneur (behaves like a full ratchet if there's a cap) or bad outcomes for the investor (you've deferred the conversation and agreement on expectations). But at the same time it is in some ways simpler, and you get the cash immediately. Right? Hmm... this is interesting. He suggests setting a price. So let's say I want to raise convertible debt... he's suggesting that one instead says "I'm raising one million at X" and sell convertible notes with a fixed price instead of a cap? What would that look like?

taytus 12y ago

Only morons start a business on a loan - Mark Cuban https://www.youtube.com/watch?v=KYneLGRTgy8 https://www.youtube.com/watch?v=KYneLGRTgy8

notastartup 12y ago

does this mean that the founders in that story accept money based on the agreeement that whatever the VC thinks their stake is is what will be the valuation? I'm a little fuzzy on how this works.

abalone 12y ago

Here's the thing that's left out of this investor-friendly analysis, and why Suster is wrong about the "irrationality" of no-cap deals: For smaller angels, access to the deal itself is valuable. Small investors don't have access to Series A. That's why the analogy with the stock market is broken: "Can you imagine investing in the stock market where your price was determined at a future date and the better that company performed the HIGHER the price you paid for that investment." The reality is angels don't have the option of purchasing the stock after the seed round. So, it can make perfect economic sense for an angel to pay a premium to get access to a deal. And if that premium comes in the form of pre-paying for a chunk of the Series A (one way to look at a no-cap deal), that can make sense -- perhaps even more sense that an enhanced seed valuation would. A discount would be sweetener on top of that. But to be clear: there is a rational case for smaller investors taking no-cap deals in order to get a chunk of the next Facebook, which they otherwise wouldn't be able to get. Seed rounds present a unique intersection point for founders & smaller angels where their interests overlap. I think the bigger-sized investor community are somewhat threatened by that, and that's why we're seeing such a sophisticated campaign against no-cap convertible notes. But the climate is now competitive enough and small-angel platforms are getting enough traction that you can sense their anxiety that no-caps may be coming back, to the great benefit of founders.

jacquesm 12y ago
That is an extremely interesting point. I never thought of it that way, seeing series 'A' with some regularity and being a (consulting) participant in the deals I never felt the urge to invest in these deals simply because that would create a conflict of interest. But the fact that the only investments that I did do were as an angel in 3 different companies was simply due to the fact that the rounds were very early and the amounts were still low enough that they were in my 'bracket' or 'comfort zone'. I guess if I felt the need or desire to participate in series 'A' I would join an established VC as a limited partner. One of the reasons VCs would not like to have a bunch of angel investors join in a series A is that there would likely spontaneously combust into existence a sort of Polish Parliament and then the deal would likely fall through. Syndicated deals have some of these aspects already, especially if the geographic and/or cultural spread of VCs is large.

vasilipupkin 12y ago

How often do companies that end up doing a round below the original cap ( effectively a down round ) actually recover and do well? Does this really matter? Seems like it is such a big risk to investors to invest below the cap that they should be appropriately compensated for it, which is what the discount accomplishes

sandGorgon 12y ago

Does anyone have a valuation model spreadsheet that accounts for multiple rounds of convertible note financing, and purposed towards a Series A conversation ? As a founder, I have tried searching for these but never managed to find one. I'm not sure if it is an India thing, where investors actively discourage convertible notes because of the availability of several pounds of equity flesh in exchange for angel stage funding.

lightedstar 12y ago

Why don't convertible notes in the friends in family scenario just set a multiple that will be suitable in the case equity is diluted? In this case it seems the main interest in supporting an entrepreneur they believe in and getting their money back - ideally at a better return than they'd get elsewhere. For example, would a 2x return on a convertible note pose any real problem to investors in subsequent rounds? Glad to see so much discussion about it. After taking Venture Deals with Brad Feld and Jason Mendelson through Kauffman Fellows Academy / Novoed, I'm quite curious about trends on this topic.

lightedstar 12y ago

jsun 12y ago

Wow. this is misleading. Convertible notes are the best things to happen to startup founders in the history of fundraising. Take a modern convertible note to an angel investor from the pre-bubble 90's and they'd laugh you out of whatever coffee shop you happen to be sitting in. All of the "examples" shown in the blog post make irrational arguments. Show me one scenario (in numbers) where using a convertible note for a seed round was suboptimal compared to an obtainable equity deal. If I didn't know better I'd think this was an example of a VC trying to smear an awesome instrument so hopefully they won't have to compete with investors willing to write them.

tsunamifury 12y ago

All of this is a distraction game played by VC's to avoid the real point of entrepreneurship. Make a product worth something to a target market. Sell it or get enough traction. Find a company who would like to buy you or go public based on your growth. All this other stuff is a distraction created to keep you from focusing on what you are here for. To build great things and sell it for profit. Otherwise... whats the point. The best negotiating term is having a great product. You won't raise your way to a product/market fit.