I've been watching with interest the trend to do seed financing as debt rather than equity, but a big gotcha on the investor side seems to be the requirement that anyone lending money in California satisfy the licensing requirements of the California Finance Lenders Law[1].
These requirements[2] are somewhat onerous: fees, fingerprints, background check, and a $25,000 bond at registration time, plus annual fees and reporting requirements. Much of the law seems designed to deter mortgage scammers and consumer loan sharks, but a convertible note that's not a "venture capital commercial bridge loan" (term less than one year, made from an LLC/Corp/Partnership that has at least 50% of its assets in venture investments) would almost certainly seem to qualify. The only other exemption seems to be to make no more than one loan in any 12-month period.
Are angel investors using convertible notes actually complying with these provisions? Are they going under the radar and hoping that noone will care? Is there another exemption to this law of which I'm not aware? (I'm not looking for legal advice, I'm just curious as to what investors are actually doing in practice - I'm interested mainly from the company side.) Compared to the relative ease at which one can become an "accredited investor" for equity financing (basically just signing a piece of paper saying you are), it seems like this would actually make equity a lot more attractive to individual investors than convertible notes, especially for those who only do a handful of smaller deals.
[1] http://codes.lp.findlaw.com/cacode/FIN/1/d9
[2] http://www.corp.ca.gov/forms/pdf/1422CFLLF.pdf
