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Bad Notes on Venture Capital (bothsidesofthetable.com)
223 points by brentm on Sept 18, 2014 | hide | past | favorite | 84 comments

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.

Agree with all of this. But on your point about convertible notes not giving governance rights that can hold up a future financing - even though this is true from a technical perspective, in my experience the later round investors will insist that every noteholder sign the preferred stock financing documents at the time of the financing in order to acknowledge their note's conversion into preferred stock. So even though the noteholders don't get to vote on the deal as stockholders, they still can hold things up by refusing to sign, asking for additional information etc... My advice to companies is always to treat the noteholders as if they were already stockholders in terms of providing them updates on the terms of the financing as it develops, giving them time to review the term sheet, and making sure all are comfortable with the deal so that you don't have any holdouts when it is time to close the Series A.

I'd add two things here:

> You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing.

If you raise a note with an $8M cap, it might not have the same impact on tax and equity pricing as an actual equity round at an $8M valuation. On the other hand, I wouldn't say the impact is zero. A share of stock in a company that's raised a convertible note is arguably less risky than one with no cash period. And while you're not necessarily legally obligated to raise above the cap, it certainly anchors expectations for future rounds. Even if there isn't a cap, there's some anchoring going on based on the amount of money raised -- i.e. if I raised $2M in notes, it's going to feel weird to raise less than that in a Series A. And to the extent that investors have expectations about the percentage of a company they want to own, anything that affects the amount you expect to raise affects your Series A valuation.

> Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round.

Note that the dynamic is technically orthogonal to which instrument you use to raise. You could (probably) draft a simple seed stock issuance that functioned similarly to a SAFE with a cap (e.g. preferred stock, 1x liquidation preference, and pull-up rights) in terms of transaction costs, flexibility, etc.

Practically though, this doesn't happen often. Again, the issue is really about anchoring. If you're going to issue preferred seed stock, you have to put some kind of language down about the rights of that stock. And while this language can always be amended, what you put (or don't put) down has the psychological effect of anchoring the Series A discussion.

I've had a good experience with priced equity seed round with no board seats, no anti-dilution, drag along, non-participating liquidation preference, and simple pro rata participation rights. When a Series A occurs, the Seed investors will get rolled into whatever [presumably stronger] rights we define at that time. A seed round doesn't need to carry any more governance or loss of control than you desire.

The deal was relatively quick and easy, and under $10k in legal. Even dealing with the SEC was quite pleasant. Ultimately I like the directness and simplicity of preferred shares. It also helps when back in 2012 we got the 100% federal capital gains exclusion on QSBS.

Regarding keeping a low stock price; your limited offering preferred share price has little-to-nothing to do with your common share pricing. It should be trivial to get a safe harbor'ed common stock valuation at PAR for 83(b) purposes, even following a $3-$5m pre-money seed round.

Just wanted to thank you for taking the time to write this.

Explaining how SAFEs work in the context of the actual process of raising money - meeting with investors, figuring out a price, needing to raise more etc was eye-opening and very useful.

Thank you again for all your comments here!

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.

This is mark (the author).

I totally get why i would be seen as biased. I have given this advice hundreds of times in small sessions verbally and I REALLY have no interest in driving my point of view for me. I do 2 deals a year. It barely matters to me personally.

Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s. I promise you you'll hear similar views to mine. Also, ask some very smart lawyers for a balanced view. I think you'll mostly hear the same.

re: gate keeper protecting the establishment. I know you don't know me but truthfully it is nothing of the sort. I think in simple life lessons. When you matter more to a small set of people they have more interest in helping you in tough times. If you never make mistakes or struggle then the argument of not having strong leads makes sense. It's just that this is the edge case.

Good luck.

Thank you for your reply on HN. Can you also please reply to grellas's post (at or near the top)? grellas is a "very smart lawyer" who posted some excellent counter-points to your original article. Personally, I'd love to hear your response.

I think grella said the advantages of convertible notes are:

1. First note is capped but later notes can be uncapped; 2. Fewer tax risks; 3. Doesn't mess up your equity pricing; 4. You can do a number of notes with different amounts raised; 5. You don't give your investors the kind of protections they would get in equity rounds.

I'd like to hear Mark's reply too. My opinion below.

I tend to think that all of these things (aside from the tax risks) are either inconsequential in comparison to equity financing (3, 4), or simply the result of having unsophisticated or uncaring investors (1, 5). The tax risks he did not explain; I assume he means the risk that the IRS would use an equity round to peg a value on shares or options given to employees that differs from what the company assumed. If so, this risk exists no matter what.

I agree that giving the investors less protective provisions or uncapped notes is better for the company. If you can get investors to agree to that, good for you, but that's separate from structure.

The primary problem with convertible notes as they are used today for entrepreneurs is that the investor gets the lower of the cap or a discount to the next round. This optionality is paid for by the entrepreneur. And while, as grella points out, the cost of this optionality is usually pretty low, so is the value of the benefits he points out.


I don't understand your "going back to the mid-90s" point.

I cofounded a company that was VC-funded in the late 90s, after having principal roles in two successful bootstrapped companies in the mid-90s.

What I don't understand about the point you're trying to make:

* Modern convertible debt financing of the form we're discussing --- unpriced rounds, rolling closes --- were not available in the 1990s.

* Entrepreneurs who fit the cohort you're implicitly defining --- people who raised VC in the 90s --- are effectively immune to the effect Patrick is describing. Executing a first VC-funded company well gets you your next VC-funded company. Nobody disputes that the priced-round VC system worked well for proven operators. The subtextual argument for convertible debt is that without it, you might not get the next Airbnb or Dropbox --- companies that barely even made it into YC.

Everyone else has covered the more substantive issues, but on your point about lawyers - as far as I can tell, there is nothing close to a consensus amongst top startup attorneys that convertible notes are a bad idea.

Part of this is that good startup attorneys can help their clients avoid most of the issues you discuss - i.e. explaining what the terms mean, explaining that discount-only notes are relatively uncommon, explaining what happens when you raise an equity round at a valuation less than the valuation cap, adding in provisions to prevent liquidity preference double-dipping, etc.

I think you are right - having a lead is very valuable - but you're also missing the other side of the argument.

Convertible notes have upsides, primarily that they give the entrepreneur significantly more leverage in a seed round. The benefits for entrepreneurs have been pretty clear in the last decade: lower dilution and much better terms.

So it strikes me that while there are certainly downsides to notes, I don't see the major upside addressed in your piece. This is what makes it seem a little self-serving, IMO, esp since the upsides you do address come across a little bit like strawmen.

I think the point of the article is that they don't give the entrepreneur more leverage. I don't think that there is a correlation between convertible note seed financings and rising valuations: valuations are rising for all types of financings over the last five years.

The downside to a note is exactly this: the cap in the note is the valuation an investor would pay. That is how I view it, as an investor. And when the next round is lower than the cap, it usually means the company is busted somehow. I am completely indifferent, as an investor, to a convertible note or equity because the outcome is generally the same for me. The reason I hate notes generally has to do with the negotiations around them (what's the term, what happens if the company gets acquired before the A, what happens if the other angels get pissy and try to claim that the company is in default, do I have pro-rata rights in the next round, etc.)

But my biggest fear with convertible notes is what the Series A VCs are going to do to me, the angel investor. They could generally not give a damn about me and since the company already has my money, I have no negotiating leverage if they decide to do anything aggressive. With an equity deal, I know what I have and, since it's very similar to what the founders have (common stock) it's hard to screw me without screwing the founders.

I'd like to know what you consider the upside of convertible notes, or how they give the entrepreneur leverage, because I just don't see them.

At a seed stage, the major cause of rising valuations is the massive competition for good deals. This is caused by the massive proliferation of angel investors. This is caused by simpler financings, including convertible notes.

Where does the entrepreneur get leverage? So many ways:

- small angel investors cant afford to spend a large amount on lawyers, so simple legal terms are enablers

- rolling closes are massive enablers. They mean you don't need a lead. Which means there isn't anyone with leverage. Which means if anyone thinks the price is too high they can drop out without affecting the price from the other investors. In fact, since you'll have cash in the bank from half your investors, you can raise with the financial pressure off, and demand a higher price from other investors.

- cheap legal fees allow smaller rounds (even a cheap priced round is 15-25k; our bill came to 42k). You can raise 100k in a weekend with no extra costs.

The massive proliferation of angels is not due to simpler documents. The massive proliferation of angels is due to the smaller amounts raised in seed rounds.

It's just as easy to use template equity financing docs as template debt financing docs. I'm not sure where this alleged complexity comes from. There is no intrinsic complexity of equity docs that doesn't exist for debt docs. I've negotiated debt docs (for real loans to companies further along that were far, far more complicated than any equity docs you've ever seen. Because having more than one type of financing in a company adds intrinsic complexity (because the interests of different parties are no longer identical.) The reason convertible debt docs are simple is because no one cares enough to legally protect themselves. If you and the investor cared that little in putting together equity docs, the equity docs would be just as simple.

You can do a rolling close with equity. At least half the equity financings I've been involved with in the last ten years have had more than one close (my firm in the 90s tried to be the only one in the round, so there was only one close.) You can also do an equity round with no lead just as easily as a debt round. Why not? The reason most equity rounds have leads is because smart investors insist on leads and smart investors prefer equity. That's correlation, not causation.

I've done priced seed rounds for less than $10k. Series A and later are more expensive because there are more reps and warranties and checking of charters and etc.

If you were to raise Priced Seed Round, you will get a lower valuation than the cap. The Notes need to be structured right, I agree with Mark on this.

If you do not have a cap, you are screwing your investors = this is very bad. You should treat your investors well and with respect. They will help you to grow the company.

If you have a cap that is too high, it will look bad in later rounds. Set the cap with current market.

If you have any control, liquidation terms in your Note = this is insane. The whole point is not to negotiate these terms when your company is just getting started. The Note should convert into the future Preferred Stock with all the rights that will be negotiated later by the VCs on angel investors' behalf. This is only fair for angel investors.

The Convertible Notes can cause all sorts of problems, sure. But the biggest point is that taking money is never free. I don't think Convertible Notes will cause more problems that Priced Seed Rounds. I actually think they cause less problems. Witness YC financing = version of Convertible Notes.

I take as a given that people will make comments that are self serving unless I have info to the contrary. Not that you have to of course (good enough to just relay the information which is definitely helpful in many contexts obviously) but shows how possibly including a preface with what you said here could further strengthen what you are taking your valuable time to blog about. (Hey it's not like your posts are short, right? What's a few more words at the top?)

When selling someone (or negotiating) I always find it helpful when people make a critique such as the parent comment. Someone a while back made a critique according to how I price a particular consulting service [1]. As a result of that one comment I changed the way I priced so as not to give the appearance that I am not working in someone's best interest. (Because I was in my mind all along but once someone questioned it I made the change and it's worked better. Reason being it's a small part of how I make money and as you said "it barely matters to me personally". But the change was easy enough so why not?).

[1] "Why then is it in your best interest to get me the lowest price (I help buy things that are very expensive) if your compensation is at least partly dependent on the amount I pay for it?"

> Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s.

Entrepreneurs fitting these criteria are highly likely to be investors. Entrepreneurs today are part-time angels after fewer companies. If such an entrepreneur is giving advice they are likely to possess any bias investors are assumed to possess, that is, if their channel to the less experienced entrepreneur isn't already predicated on the potential for investment.

This would not be a good test for proving or disproving bias.

In addition to everything suggested here, I'm also very interested in understanding the following question:

how on earth are an investor and an early-stage entrepreneur supposed to come to a valuation number when the history of the company is pretty much non-existant and the projections of financials are a shot in the dark at best.

Sales and Faith. With a pre-revenue, pre-launch company, from the entrepreneur's side, it is pure sales. And from the investor's side, it is pure faith.

Build a good story, believe in it, and sell it. I can build a financial model with the best of them. But as Brad Feld once said about all early stage companies, "Your revenue forecast is wrong." You have to believe enough in yourself and your company to convince someone else to believe in you and back that up with cash.

It's a bet and always will be. And like any bet, some are more sure than others. But lots of "sure things" fail, and more than a few long-shots win and pay out big. Sales and Faith.

Mark - It's natural for us to assume people are "talking their book" when they give advice. (How many CEOs talk about "Working for passion" as an excuse to underpay?)

Thank you anyway for joining us here to share your contrarian view. If everyone agreed with each other, this would be a very boring place.

> Is there an entrepreneur willing to say "Yep, tried them, got bitten in the hindquarters",

Kinda, but in a different way. When we were raising our Series A round, some investors based their offer off our Seed round's valuation. One investor thought that our seed round was a capped note, and wrote us a term sheet that was a "generous increase over your cap" (I think 20% perhaps). I think if they had known the seed was a priced round, they would have made something more like a 100% increase over it's valuation.

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.

Not entirely related but to the point of Mark's 'bias'. I had a meeting with him many years ago when he just got started at GRP. Despite his very clear 'No' to our pitch, he gave some of the best, and direct, advice I received and nearly 5 years later it is still serving me well. It allowed me to do what I wanted without needing to raise money at that point. Of course that makes me biased towards his post so take my opinion with a grain of salt :)

That said, Mark seems one of the guys that really likes to help entrepreneurs. I read his post not as "Don't ever do a note" but "be very aware of unintended consequences". As I am starting to fundraise for a new company, I've felt incredibly uncomfortable with convertible notes for the reasons Mark outlined in his post. I thought I was being paranoid since everybody is saying notes are the way to go, so it is nice to read an opposing view.

YC founder here.

One major problem with convertible debt in that it is fundamentally debt with an X year term and Y% interest rate. If the startup chooses not to raise further capital, the note does not dictate what is done (at least ours didn't).

This isn't much of a problem if your investors are really nice, smart people. But if they aren't...

I've had the experience of a non-entrepreneur-friendly investor calling the debt (e.g. demanding repayment after the term had expired) at a time when our startup couldn't make a payment of that size. They refused to extend the term. The investor then threatened to liquidate the company if we didn't pay them back.

Some of my cofounders had made money in the past, so we repaid the debt by having them lend money to the company. But I'm not sure what we would have done if we didn't have that option.

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.

Congrats on 100,000 karma, btw. O_o

Thanks. Man, inside Valley baseball, wouldn't have guessed that would be the cause 6 years 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.

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.

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.

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.

How many of those 90 were convertible notes, to put this in perspective?

Roughly half.

And is your point then correlation == causation?

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.

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.

> 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?

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.

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.

Exactly: Tech angels who are not LPs in a VC fund are largely limited to the seed-stage investment market. Therefore founders can negotiate better terms (e.g. no cap).

Superangels / mini-VCs / actual VCs like Suster don't find it as appealing because they have plenty of Series A deals come their way.

But then again I bet they would bite at a really quality opportunity at the seed stage, because the best companies will seek larger funds at their Series A than what superangels can offer. (So they're not necessarily seeing the best companies at Series A.) Part of me thinks this "no cap's for suckers" blogstorm is just FUD to improve their collective negotiating position.

The only thing dumber than a superangel taking a no-cap convertible debt deal is a superangel passing on the next Facebook's seed because they didn't want to pay Series A prices. That would be incredibly shortsighted.

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.

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.

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?

The article's discussion of 90 day "top up" terms seems to address that.

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.

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.

It's my impression that everything he says, if true, can also be applied to YC safe. Is that correct?


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.

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

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.

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...

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.

Are convertible notes treated as debt before the conversion happens - i.e. are they liabilities on the balance sheet before then?

Yes, convertibles are a debt instrument and can even have interest payments attached to them.

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.

Fred Wilson's series "MBA Mondays" is a great place to start:


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.

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?

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

My current impression is that the "full ratchet" he's referring to is conceptually just the deferred valuation itself.

Check out the 'more details on Convertible Notes' link for the answer to your question.

Thanks, you're right, that's a really useful link.


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?

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.

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.

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.

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

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

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.

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.

According to Mark Suster's earlier article - 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.

re #2: Yes, many notes have the provision to make sure the investor gets a 1x preference on dollars invested (some preferred and some common for their investment.) and this is, IMO fair.

re high resolution financing: if you are offering different investors at different prices, you are likely to make your investors less than happy with you.

re less control and no board seats: in my experience, having a board correlates strongly with success. so i think this is a negative. to put money where my mouth is - for my last startup, I took a board even though I did not have to.

re raising a few hundred thousand or less: in my experience, strongly correlated with startup death.

re high res financing: closing dates can also vary in addition to cap. i've personally experienced varying closing dates with same cap and the initial bit was much needed at the time. haven't experienced priced yet but can imagine process being a bit slower.

re less control and no board seats: agreed. though i think it depends on the board member. in your case, i'm sure he was top notch :)

re raising few hundred thousand or less: hmm, don't have enough data. but uber's initial round was $200k. https://angel.co/uber

Uber was cofounded by someone with a large exit. This number does not represent the actual finances available and is likely misreported. I have a single exception to the low initial raise as well. Still anecdata and does not really refute the point. There are successes, but there are way, way more failures; early investors hate to reinvest pre-traction.

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.

Any more good pieces regarding this topic? Super interesting!

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

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.

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.


I've read that Microsoft has always had enough money in the bank to operate for a full year without making any money.

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.

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.

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