The Two Disadvantages of Convertible Notes

For a number of years, new entrepreneurial startups have been financed by an invention of lawyers: the convertible note. These notes are fairly simple to produce from a legal point of view and are therefore inexpensive. Until recently, they were the vehicle of choice for startup seed rounds. However, the startup community has begun to perceive disadvantages.

Convertible notes are simple, unsecured notes convertible into preferred stock at a discount (usually 20 percent) to a Series A round usually led by a VC. Typically, the notes are sold to friends, family and angels who really believe in the entrepreneurial team. Financing amounts are generally less than $500,000—in many cases less than $100,000. The justification for the notes is that friends and family are not equipped to do an intelligent valuation, and it should be left to the professionals to finance a Series A round of, say, $1 million or more.

The first problem is that the risk reward between the seed round and the Series A investors is not reflected in the 20 percent discount. The seed round is much riskier than the next round. The role of seed funding is in many cases to get a website running and demonstrate traction in getting users and generating revenue. Once that is accomplished, the role of the Series A round is to provide growth capital to attract more users and to strengthen the site. Many startups don’t get enough traction to justify a Series A round and go out of business. Friends, family and angels typically get little or no money back. A discount of 70 to 90 percent would better account for the real risk they take.

A second disadvantage is the nonalignment of incentives between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.

Simply, the founders are taking advantage of friends and family by raising money with this convertible note structure. VCs like this structure because they are able to get a larger percentage of the company than they would if the seed investors had a more reasonable valuation.

A simple solution is to put a cap on the valuation into which the notes will covert. It effectively puts a valuation on the seed round. Founders should want to be fair to friends and family and make the valuation reasonable. As long as the next round is priced higher than the cap, both founders and seed investors want the valuation as high as possible so the incentives are aligned. The valuation cap  should reflect the aforementioned risks inherent in startups . In my experiences, these caps have run from $1.5 million to as much as $15 million for a third-time, very successful, serial entrepreneur.

The notes with caps would still be inexpensive to produce and have no other disadvantages versus convertible notes without caps.

 

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