

Why Seed Investors Don’t Like Convertible Notes - prakash
http://www.cdixon.org/?p=252

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grellas
Convertible notes are great bridge instruments that, in practice (at least in
my experience), do not create any particular friction between the bridge
investors and the later angels or VCs who fund the qualifying round forcing
conversion. VCs typically accept the 20% differential without any problem. A
bigger practical problem in my experience are bridge investors who push for an
even larger discount. On this point, founders just need to hold a firm line.

The biggest practical problem with these notes from the bridge investor's side
is what happens if the startup finds an exit path before a qualified funding
round occurs. In the worst case, such investors effectively find themselves in
a position where they get only their money back with a little interest - and
all for having taken the largest funding risk of all (not quantitatively but
qualitatively, since the early bridge money comes in at the point where the
startup is at its most under-developed).

The problem is mitigated by putting in provisions for a so-called "merger
premium" - that is, a 2x (or some other multiple) payout in the event of a
liquidation that occurs before a qualified funding. This is not a perfect
solution, but it helps. I have also seen the opposite problem here, where
bridge investors demand a "merger premium" that becomes almost extortionist -
this only works, of course, if the startup is utterly despairing for cash
(which does happen from time to time).

That said, the utility of such notes is beyond question. The problem of a
premature value put on a startup's stock based on an arms-length investment is
huge. It messes up option grants to early-stage people. It enhances tax risks
for the founders if a valuation is done too closely to the time of the founder
grants. And it puts the company in a position where it needs to start doing
409A valuations at a time when money is particularly tight and they can least
afford to part with the cash needed to do them. The convertible note
eliminates all of these problems with a pretty elegant solution. That is why
it has become a staple in the startup world.

Such a note can also be prepared at the cost of a few thousand dollars max in
a typical case, which is another plus that gives it large appeal among
founders looking for bridge solutions to their funding needs.

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timcederman
How embarrassing. One of the best first comments, chock full of _really_
useful information that is difficult to discover on your own, when I finally
get the dreaded iPhone smush and downvote it to 0. My apologies, I'm sure
you'll have your karma back shortly.

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grellas
No problem. I appreciate the kind words. And thanks for fessing up. :)

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newacc
just wondering about pros and cons of offering founder's stock to early seed
investors? I know few incubators/investors asking for the same ....

