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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 u

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.
  - arbuge 12y ago
    How many of those 90 were convertible notes, to put this in perspective?
    - joshu 12y ago
      Roughly half.
  - not_that_noob 12y ago
    And is your point then correlation == causation?
    - joshu 12y ago
      The stronger companies tend to do Series A over convertible notes. The trend toward notes is easier, but not better for startups. BTW: By "average" I mean that the sum of dollars invested versus the sum of dollars returned or marked to market.
      - mbesto 12y ago
        > The stronger companies tend to do Series A over convertible notes. Would it be fair to say that the stronger companies also tend to have either (1) strong fundamentals (i.e. historic financial numbers to base a valuation on) or (2) rapid growth (i.e. the future is clear and the network effects are clearly on the horizon). My general assumption is that most angel deals are done "pre-curve" and equity deals are done during the curve. Every investors wants to be during the curve as it's the highest upswing in short term returns. The better argument here is probably - why are angels even entertaining debt deals then?
      - nostrademons 12y ago
        Isn't that because stronger companies have more access to a Series A? I thought the point that's being made by other commenters on this article (grellas et al) is that convertible notes are frequently used for bridge financing to keep the company going when they don't yet have the product/traction milestones needed to justify a Series A. In this case, the alternative is going out of business. It's quite possible for the average convertible debt startup to be worse than the average Series A funded startup, and yet for taking that note to be a good move for any one single startup that happens to be in that position. The averages are bad because it allows more marginal startups to be funded; the specifics are good because it allows more marginal startups to be funded. I suppose one take-away for founders could be to beware the signaling risks of taking convertible debt if you are, in fact, good enough to raise a Series A. Another might be to do everything possible to get traction before running out of money. Both of those are fairly well-known already, however.
austenallred 12y ago
I don't think anyone should read this as, "Convertible notes/SAFEs are bad." I would bet that for every one entrepreneur that has been screwed by having too high of a cap there have been 9 who have benefited from being able to quickly raise money on convertible notes or SAFEs without pricing a round. This article is simply a warning that using a convertible note without any consideration to potential consequences in future rounds is a bad idea. A convertible note isn't necessarily a free pass that lets you say, "I don't have time to figure this all out right now" -- if only anything were. There are a few ways you can screw your company up raising convertible notes; there are a million ways you can screw your company up raising a priced round. At the end of the day, you have to have good mentors and lawyers to make sure you're not doing something stupid while you worry about building your company. As Mark Zuckerberg said at Startup School, and I may be paraphrasing, "The biggest mistake a startup can make is worrying about all of the mistakes they could be making." There's no way to get through unscathed, so have people who understand it better than you to make sure you're killing the closest snakes, and keep building a great company.

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.
- arbuge 12y ago
  How many of those 90 were convertible notes, to put this in perspective?
  - joshu 12y ago
    Roughly half.
- not_that_noob 12y ago
  And is your point then correlation == causation?
  - joshu 12y ago
    The stronger companies tend to do Series A over convertible notes. The trend toward notes is easier, but not better for startups. BTW: By "average" I mean that the sum of dollars invested versus the sum of dollars returned or marked to market.
    - mbesto 12y ago
      > The stronger companies tend to do Series A over convertible notes. Would it be fair to say that the stronger companies also tend to have either (1) strong fundamentals (i.e. historic financial numbers to base a valuation on) or (2) rapid growth (i.e. the future is clear and the network effects are clearly on the horizon). My general assumption is that most angel deals are done "pre-curve" and equity deals are done during the curve. Every investors wants to be during the curve as it's the highest upswing in short term returns. The better argument here is probably - why are angels even entertaining debt deals then?
    - nostrademons 12y ago
      Isn't that because stronger companies have more access to a Series A? I thought the point that's being made by other commenters on this article (grellas et al) is that convertible notes are frequently used for bridge financing to keep the company going when they don't yet have the product/traction milestones needed to justify a Series A. In this case, the alternative is going out of business. It's quite possible for the average convertible debt startup to be worse than the average Series A funded startup, and yet for taking that note to be a good move for any one single startup that happens to be in that position. The averages are bad because it allows more marginal startups to be funded; the specifics are good because it allows more marginal startups to be funded. I suppose one take-away for founders could be to beware the signaling risks of taking convertible debt if you are, in fact, good enough to raise a Series A. Another might be to do everything possible to get traction before running out of money. Both of those are fairly well-known already, however.

austenallred 12y ago

I don't think anyone should read this as, "Convertible notes/SAFEs are bad." I would bet that for every one entrepreneur that has been screwed by having too high of a cap there have been 9 who have benefited from being able to quickly raise money on convertible notes or SAFEs without pricing a round. This article is simply a warning that using a convertible note without any consideration to potential consequences in future rounds is a bad idea. A convertible note isn't necessarily a free pass that lets you say, "I don't have time to figure this all out right now" -- if only anything were. There are a few ways you can screw your company up raising convertible notes; there are a million ways you can screw your company up raising a priced round. At the end of the day, you have to have good mentors and lawyers to make sure you're not doing something stupid while you worry about building your company. As Mark Zuckerberg said at Startup School, and I may be paraphrasing, "The biggest mistake a startup can make is worrying about all of the mistakes they could be making." There's no way to get through unscathed, so have people who understand it better than you to make sure you're killing the closest snakes, and keep building a great company.