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Convertible and SAFE notes (avc.com)
108 points by ikeboy on March 12, 2017 | hide | past | favorite | 44 comments

It's really not that hard to understand how these notes convert and how much you are diluting if you spend just a few minutes modeling it out with https://angelcalc.com

Of course it's still possible to get more dilution than expected if you raise at unrealistically high caps (or uncapped!) and convert at a lower valuation down the road, but even that is probably less painful than a conventional down round.

Agreed. We walked all our angels through a 3 scenario (low, goal, home-run) Series A pre-money valuation analysis using a calculator. Bit overwhelming for some but everyone appreciated the effort.

The biggest benefits of the note structure to us were a) Rolling close b) Not wasting time debating "valuation" when neither us nor the angels were capable of estimating a number with limited to no data.

How does a safe prevent you from debating valuation? It seems like a safe note with no discount is rarely a good deal unless you hit the valuation cap (why not just wait until A otherwise?), and if you do hit the cap it's essentially equivalent to investing in a round priced at the cap (a little worse due to preference caps).

In what way is the cap not a "valuation"?

The argument for a seed investor to invest in a SAFE note with no discount and no cap is that the Series A round will be priced by a VC or superangel, and the seed investor will not otherwise have the opportunity to invest at that later point. That is, the seed investor is trading the opportunity to participate in an investment at all for control over the exact terms. But since neither the entrepreneur nor the seed investor have any idea what a pre-revenue company is worth, they're often fine delaying the valuation question.

So we raised on a convertible note with a cap and a discount. We're from the east coast and our accessible angel pool balked at SAFEs. An argument for a different thread :-).

I'd defer to Paul's point that choosing a too high (or non-existent) cap makes no sense. We did have to negotiate our cap and we set it so that we had a realistic shot of hitting 2-3x that in Series A pre money which in my mind is why an angel should be investing. I'd personally consider it a disappointing outcome if I raised at my cap and I'd hope my investors would as well.

A cap is not a valuation and I agree that everyone thinking it is, is a problem.

>> why not just wait until A otherwise

1) For a VC: more performance info / better access to the A.

2) For an angel: most angels won't have access to the A, so seed rounds are their chance to invest early in a potentially VC track company.

>Not wasting time debating "valuation"

+100 on this. This is particularly problematic in India where most early stage investing is priced. The opportunity to bully founders to accept weird valuation terms is limitless.

notes are a trade-off of current capped valuation for future capped dilution. Guess which one gets misused by investors ?

Yeah, I've never heard a founder regret using a SAFE because of the confusion.

Mysteriously, the only people who oppose SAFE notes are investors who would like you to instead enter a complex negotiation with them!

This isn't as epic as the "extended option exercise periods screw employees! Really!" post from Scott Kupor of a16z (http://a16z.com/2016/06/23/options-timing/), but close. FFS.

The "bad case" alternative to the second/third round of notes is often a down round or running out of money -- way worse.

The "good case" alternative of a second higher cap note batch is fine.

Founders and early investors can get screwed even if they raised as equity early on, too.

(Er, sorry, didn't mean to be this mean; I'd been stuck in flight delays for hours.)

I do think the analysis is both incorrect in conclusion (SAFE is the best choice in many/most cases for both sophisticated founders and new founders), and the case badly supported in the blog post.

But it probably isn't someone doing the equivalent of pushing a self-serving agenda, which was my instinctive reaction and thus defensiveness.

(I'm a seed-stage VC, but as a caveat I'm not an expert when it comes to cap tables.)

He's an example of where having many notes can hurt founders:

- Raise $2m at an $8m cap, 15% discount.

- Raise $2m at an $18m cap, 15% discount.

- Raise $2m at a $28m cap, 15% discount.

- Sell 20% of company for $X in the Series A.

Caps are "sort of" like pre-money valuations, so the founder might expect that their dilution from the 3 notes is approximately 2/10 + 2/20 + 2/30 = 36.7%

Here's what actually happens in 4 different scenarios:

1) Raise $10m at a $40m pre. Dilution from the notes is 20.0 + 8.9 + 5.7 = 34.6%

2) Raise $7.5m at a $30m pre. Dilution from the notes is 20.0 + 8.9 + 6.3 = 35.2%

3) Raise $5.0m at a $20m pre. Dilution from the notes is 20.0 + 9.4 + 9.4 = 38.8%

4) Raise $4.0m at a $16m pre. Dilution from the notes is 20.0 + 11.8 + 11.8 = 43.6%

For the founder, #1 and #2 are better than expected, #3 and #4 are worse. It's not hard to get into situation #3 or #4 if you raise money from strategic investors or angels at high caps, and then Series A investors drive your price down below your most recent caps because that's where the market is. The 9% dilution difference between the first and last scenarios is fairly dramatic. When you combine that with the 20% dilution from the Series A, it's the difference between founders and employees having ~45% of the company vs ~36% of the company.

(Source of calculations: https://captable.io/company/8/convertible-notes/calculator)

Thanks for laying all of this out. I guess we will have to do more of this to get this crew here to understand what I'm trying to explain

Isn't that functionally just a down round?

Yes. But based on my understanding of conversion mechanics, the anti-dilution terms in priced seed rounds are often "weighted average" (which are more founder friendly) while in SAFEs and notes they are closer to "full ratchet" (which are founder unfriendly). An example of the two types of anti-dilution provisions is worked out at https://www.strictlybusinesslawblog.com/2014/03/08/venture-c...

It's great when a VC makes a pro-VC argument and without any hard data cites feelings as the reason why founders should do what he says. AVC has some great ideas, but sometimes it's pure propaganda.

If you're just raising a small seed in order to get something going, what's more important than moving fast and getting the product to market?

This is not a pro VC argument. You may want to believe that. But that's not what I'm trying to say

I'm ambivalent about notes vs priced rounds for founders. I agree that they create nasty surprises at conversion time.

But notes/SAFEs are great for the earliest employees since we can grant them real shares instead of options. Plus, we can do it at par value.

Shares granted before a priced round are typically identical to the shares a founder has, with all the same tax advantages.

Doing priced rounds early means having to worry about a 409a early, and probably giving employees worse quality equity (or creating income tax problems for them).

Huh? Surely you cannot do 83b election for the employees who joined after 30 days since the company formation?

And if you don't, that makes situation a lot worse for the employees, as they end up owning taxes at each vesting event.

83b doesn't have that restriction. You just have to file within 30 days of receiving the shares. Can be indefinitely long after company formation, since it's an election made by the employee, not the company.

I'd recommend https://www.amazon.com/dp/B01M3UIVW3/ref=dp-kindle-redirect?... if you want to learn all the details -- it is a great reference.

The concern I think you have is that FMV of the shares might have increased after company formation? That is what 409a is for, but you generally have a decent window between reassessments, especially early on. (6mo? Is what I've seen)

83(b) clock starts when the restricted grant is issued to employee. The price is set at that time.

I really really dislike when VCs make a pro-investor claim and try to hide it in founder-friendly terms.

Priced rounds are great for VCs because they remove all their risk. But they don't remove any founder risk. Do a down-round after a priced round and you'll wish you were just taking more dilution from a SAFE.

> "1. They defer the issue of dilution until a later date".

When the company is doing well, notes allow founders get less dilution, sometimes way less. This is great for founders, and is just about the only time in the whole startup thing where things go better than expected for founders.

If the company is doing badly, I'll take a lower conversion rate over having to raise a down-round any day.

> "2. They obfuscate the amount of dilution the founder(s) is taking. I think many investors actually like this"

He sets up a moral imperative: you're an irresponsible founder if you don't know what dilution you're taking. But I know what dilution I'm taking: it's X _or less_!! (Again, in a down-round I'm fucked either way, so the downside of notes doesn't matter)

> "3. I cannot tell you how many angry pissed off angel investors [..] they own a LOT less than they thought they did."

And here we get to the crux of the issue, investors own less. If investors own less, who owns more? Founders do.

> "4. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG."

"Silly inexperienced founders accidentally give investors a bad deal. This is morally WRONG". Needless to say, I'm unsympathetic to this view.

Look I understand why VCs don't like notes. But to pretend that this is a founder-friendly thing is beyond irritating (note: he's far from the only VC to do this!). And this is one of the reasons I trust YC far more than any other investors - they're in it to help people make startups and they argue for founder-friendly terms.

(PS there is a real issue in that inexperienced founders might raise too much thinking its free money, and then they get a lower cap than expected. But my only bad experience with raising with notes is that VCs treat it as a lower implied valuation when raising the next round.)

Exactly. Pissing off an angel investor because some equity goes to the founder instead of the angel is bad for a VC, because that VC needs that angel to help funnel them deals in the future. But it's good for the founder, because the founder keeps more equity.

This is a very disingenuous argument by Fred Wilson, which is a shame because his analysis is usually so intelligent. But when it comes to convincing founders to give VCs more equity, he's driven by his own incentives just like any VC.

I wrote this from the heart. You can ascribe whatever agenda you want to believe. But I wrote this for founders and it is based on thirty plus years of working with founders. I don't want to see them get screwed and notes screw them over a lot

Thanks for saying that!

I don't have any agenda or ascribe any to you. All I think is that to the untrained eye, this post comes across as founder-unfriendly.

Could you poke holes in his/her arguments? Or perhaps cite examples? The counterpoints seem convincing but, hey, I might be totally missing something.

For context, I'm a long-time fan of your writings and REALLY appreciate how much you've given to the community (with the only VC blog worth reading IMO). Just want to fully understand the issue at hand here.

I believe that. Yet, I think founders getting screwed over is largely orthogonal to the type of instrument used to fund companies in the early round. The scruples and sophistication of the parties involved play will tend to play a bigger role.

Among the asserted merits of SAFE's when the came into the YC ecosystem was that it removed some of the distraction that trying not to get screwed over created for founders at 'demo day' or earlier stage companies. At the time, an investor's willingness to use a SAFE might have had an inverse correlation to their willingness to take undue advantage of unsophisticated founders.

Also the biggest issue - it defers the question of valuation. That is a huge thing in pre-product/pre-traction stages when valuation is what you believe in.

99% of first time entrepreneurs have a simple question - "how do you value an idea, an early stage startup": It completely eliminates this question.

There should be better ways to know how to "value an idea.". I believe that there are better ways, that the VC-startup world does poorly there with biggie costs on the both sides of the table, that there are some good examples of the ways, and that, really, we are awash in both how to do this and examples.

First, we start with evaluating ideas. Gee, guys, the research community does that many times daily. A researcher who pursues dumb ideas in a few years is known as a poor researcher. So, good researchers know how to evaluate ideas.

The researcher's superiors, the proposal reviewers, and the funding agencies also all know how to evaluate ideas and where here the ideas are just research directions with the ideas not really formed yet.

Moreover, for publication in peer reviewed journals of original research, the standard criteria for evaluating the ideas in a paper are "new, correct, and significant", and these criteria get applied with good accuracy.

Moreover, for a Ph.D., one way to evaluate the work is "an original contribution to knowledge worth of publication." And, before a Ph.D. student starts their research, they and usually also their faculty advisers have to evaluate the research direction, even before a solid idea.

The US NSF, NIH, DARPA, ONR, etc. are also quite good at evaluating research directions well before a finished idea.

Of course we can evaluate ideas, especially ideas already polished and ready for publication and also finished, polished ideas already implemented in solid, running code.

Then, sure, that evaluation does not necessarily lead to business success, that is, traction, revenue, earnings, money in the bank, an a good ROI and exit for investors. Right.

But, wait, there's more!

Second, here's a severe way to evaluate such a polished idea ready or nearly so to go for first traction: Or, with the running software, can see that it works. Now the severe question is, "Is that software a must have solution with enough users/customers and revenue per each to make the big bucks or is that software just a nice to have and/or for just a niche?" And we will want to know about barriers to entry, scalability, etc. Doing well on these criteria should be darned good signs.

Apparently instead the VC community wants to judge based almost entirely on traction and rate of growth in traction. Yes, that's hard headed; it's also dumb headed, ignoring important information.

Some businesses do quite well with new ideas:

Xerox did well with the research direction of electro-static photocopying -- from just the research direction through creating a major company.

At each smaller step in line width, Intel does well. Who would have believed 1 billion transistors on a postage stamp with line width 14 nm?

The pharmaceutical companies that do original research make their money on picking good research directions and then doing good research.

And may I have the envelope, please [drum roll]! The all-time, unchallenged, unique world-class, grand champion of going from mere research directions to world changing results is the US DoD. Second and third places are occupied by the NSF and NIH. Intel, some of the pharmaceutical companies, and more are also on the award stage. VCs need to start learning up from those examples.

The VC approach would have been, "You build and test the first one, and we will chip in for the gasoline for the Enola Gay."

Instead, IIRC from books of Richard Rhodes, the Manhattan Project cost ballpark $3 billion in 1940's dollars.

Okay, big, expensive waste just from war time, right? Maybe not: Let's divide $3 billion by one million -- right, even without a super-computer, that's $1000.

And the relevance? The estimates were that a US invasion of the home islands of Japan would cost the US 1 million casualties. Given the experience at Okinawa, Iwo Jima, etc., the 1 million was believable. So, the Manhattan Project saved expected 1 million casualties at, right, from the arithmetic, $3000 per casualty. Grand bargain just from the money alone! If your father, son, brother, uncle, etc. were one of those casualties, then you would have regarded the $3000 as a grand bargain.

And the Manhattan project spent money like it was worthless -- cost no object or concern. Good ideas are like that.

Thank you graycat, for the excellent thoughts and analysis.

I doubt you are a VC but maybe you should start your own firm.

The VCs keep pushing the 'stage ask' further upstream every year. So, what used to be considered good for A round traction/revenue/MAU is now considered Seed and so on up.

They'll only want to invest when 'I know this is the winner in this category', but I'll call it Series A and Series A has always been done at valuation $x.

FU! You won't fund a deal till it's profitable and all the risk is taken off. But, I need to get money from somewhere! So, I'll get it from small angels and individuals. And since I have to collect it 25-50K at a time, I can't do a priced round.

You set this board up, now don't complain that you have to deal with the mess.

[Edit] And if you'll only be dealing with a startup once it has gotten some level of success, you have no option but to deal with the mess, if you want the deal.

>> "3. I cannot tell you how many angry pissed off angel investors [..] they own a LOT less than they thought they did."

>And here we get to the crux of the issue, investors own less. If investors own less, who owns more? Founders do.

I think in this case there are just "more investors than the earlier investors expected to exist".

In any case, if there's a subsequent convertible round after the round you were in, of course there will be more dilution for the angel! And honestly if the subsequent noted were raised at higher caps comparable priced rounds, then the dilution to the earlier angels should be less anyways. This just sounds like optimistic angels not understanding the equations they are a part of.

Frankly said angry Angel should recognize that any subsequent round dilutes them and the founders in similar fashion, and any instrument that is "founder friendly" is existing investor friendly as well by definition.

> This just sounds like optimistic angels not understanding the equations they are a part of.

I agree. I edited out of my rant the fact that investors are supposed to be sophisticated. Everyone knows what they're getting into here. Angels are typically way more sophisticated than startups (if you've done 1 deal that's usually 1 deal more than a founder has). If you can't do the math on this you shouldn't be investing in startups.

This totally misses how painful it is for a first-time founder to negotiate against an experienced VC. The power of the SAFE note is that you don't need to worry about the terms, you know it's acceptable. If there are twenty different possible funding mechanisms and you have to negotiate which one you want, the power goes to the VC. Just use a SAFE note.

This bit of (excellent) guidance is actually two somewhat separate suggestions:

"Founders should insist that their lawyers publish, to them and the angel/seed investors, a “pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “pro-forma” cap table should be updated each and every time another note is isssued. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it."

Requiring that a cap-table be published is somewhat different than ensuring that the founders understand their dilution. It's quite likely there is a ton of overwhelming information/events going on during a close, and it's easy (though it shouldn't be) at this stage for a founders eyes to glaze over yet another-table. But taking the extra 60 minutes to walk through the implications of dilution, and ensuring that they actually get it is something a responsible investor/VC will do.

I'm not seeing what is confusing about dilution, or how that is exacerbated by multiple note rounds. Can anybody give an example along with the correct and incorrect interpretations of terms investors are prone to?

"or how that is exacerbated by multiple note rounds" - YES - I too am looking for a clear and concise example of this. The only people that have ever suggested this to us were....VCs and from my reading and rereading of all of our notes, its very unclear as to why this would be some sort of actual surprise/issue.

This article assumes naive founders and doesn't mention the many situations wherein convertible notes and (especially) SAFEs are very advantageous to the founders.

I wonder which situation is more common?

It's even funnier: SAFE notes are very advantageous to naive founders as well...

This is super light on concrete info, can we have some examples of this house of cards? and of angels getting screwed?

Maybe these endless rounds of financing even when the company is selling product aren't such a good idea. The result is often a chicken run for the bankruptcy cliff. Can you buy dominant market share before the investment money runs out?

Looking at you, Uber.

> They defer the issue of valuation and, more importantly, dilution

That's what the cap if for. If the founder is 19 years old, fine, read a book on it (I recommend this: https://www.amazon.com/Funded-Entrepreneurs-Guide-Raising-Fi... but basically any will do) but angel investors that don't know what caps are are dumb angels.

> They obfuscate the amount of dilution the founder(s) is taking.

Also what a cap is for. Unless we're talking about it from the founders perspective, in which case it's their decision to raise another round or not. If the dilution doesn't make sense don't raise the round. If you're desperate and were banking on hitting the cap maybe the company wasn't worth what you thought it was worth when you raised your Angel round.

> They can build up, like a house of cards, on top of each other

Here I 100% agree. Early family and friends money or angel investments or small seeds should be convertible, but subsequent rounds should be priced, or a down round is going to eviscerate the cap table.

> They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert.

What? How? Only if the founder is lying or doesn't put in a cap can I possibly see this happening.

> The company has been around for a few years and has financed itself along with way with all sorts of various notes at various caps (or no cap) and finally the whole fucking mess is resolved and nobody owns anywhere near as much as they had thought.

False dilemma. The choice isn't "use convertible and get a fucking mess" or "do priced rounds for equity and keep things clean". If you keep your capped convertible round simple and follow it with a priced round for normal equity anyone with two brain cells can figure out what the outcome will be given different scenarios. I've seen some really, really fucked up priced rounds because some dumb angel investor took a dump on the shareholder agreement and it took hundreds of thousands in legal fees and payoffs to fix by the time they were going for what they ended up calling their seed (they renamed their small seed their angel round).

> It can easily be done for less than $5k in a few days and we do that quite often.

That isn't the issue. The issue is that a bunch of regulatory issues come in once a company is selling stock that a two person startup doesn't want to waste time dealing with.

> The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me.

What? Is this at the idea phase or something further along? Because I don't know anyone that has a $1M cap if there is any serious amount of work or team.

> Don’t do multiple rounds of notes with multiple caps. It always ends badly for everyone, including the founder.

I agree. Only do this if you're desperate or if you raised a tiny angel round (<5% after cap).

> [...] a “pro-forma” cap table at the closing of the note

I agree, though more as a CYA thing to keep relationships good than something I think would be necessary if the founder set up a sane round in the first place.

I'm personally not a fan of SAFEs because they can get hairy when you have lots of angel investors, but convertible is great.

As a partial aside, this whole "strong views weakly held" (see http://avc.com/2016/06/strong-views-weakly-held/ for more details) is kinda annoying to debate with because it frequently boils down to me having to colour in the nuance. It's like a less extreme version of arguing with Trump supporters.

My style is:

Strong views strongly held, until they're no longer strong views because they've been eroded away by building, credible counter-arguments. I generally stop talking about the view during this period or when I do talk about it I'll ask questions. I think of this as weak views weakly held. Then I re-investigate the view's premises and:

1. If finding my original assessment still broadly correct, I evaulate the counter evidence and modify the view to include a greater degree of depth, since I now understand a further degree of the complexities. The view then becomes a "nuance aware-strong view, strongly held".

2. If finding my original assessment false, build a new strong view (strongly held) from the premises of others.

Strong support carries information "this information should be trusted" and I don't like broadcasting that signal if my view is weakly held.

> The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me.

By "cap" in this context, I believe he's referring to the aggregate amount of convertible notes.

Ah, nice catch. In that case I generally agree with him.


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