Convertible debt for startup seed rounds
You have a startup company, and you are looking for funding from investors. Finally, after countless hours of hard work, you have an offer for your seed round. This offer is in the form of a convertible note. Do you accept it?
You may be tempted to jump on the first investment proposal you receive. It gives you validation, and you obviously do not want let an opportunity slip through your fingers. However, ask yourself if you understand the potential consequences of accepting a convertible note for your startup seed round.
What is a Convertible Note?
I’ll let FundersClub define it for you:
A convertible note is an investment vehicle often used by seed investors investing in startups who wish to delay establishing a valuation for that startup until a later round of funding or milestone. Convertible notes are structured as loans with the intention of converting to equity. The outstanding balance of the loan is automatically converted to equity at a specific milestone, often at the valuation of a later funding round.
Most importantly, you need to understand that the valuation of your company is not negotiated by the investor and you. Theoretically, it makes the investment process a little easier, but it may become an issue during your next round of financing.
The Typical Argument for Convertible Notes
When I ask entrepreneurs why they decided to accept or request a convertible note, the typical answer is usually something along the lines of the following: “It was cheaper and quicker than a straight equity deal.”
Is this always the case?
Convertible Note Myths
Are convertible notes always cheaper than straight equity?
Not always. I would bet that you could find a law firm that is willing to complete an equity deal for less than $10,000. I have even heard of law firms doing it for $5,000. The law firm may not make a profit from this deal; however, if your company has the potential to provide future business for the law firm (i.e., additional rounds of funding), the law firm may accept a lower price for the service.
Are convertible notes always faster than straight equity?
I do not buy this argument. Numerous factors can prolong a deal, but at the end of the day, equity deals can be completed in less than 10 days.
What I want to convey to you is that the “cheap” and “fast” perceived benefits of a convertible note are at most minimal. Therefore, don’t let that be the sole reason you accept a seed investment in the form of a convertible note.
Think of it this way: would you buy a Porsche Boxster over a Porsche Cayenne if it was $1,500 cheaper and you would receive it three days faster? If you are already spending thousands of dollars on a luxury vehicle as a long-term investment, those minuscule differences should not affect your decision. You need to assess whether a two-seater coupe fits your needs better than a family-sized SUV.
There are numerous potential consequences that may result from accepting a convertible note for your seed round, and I will discuss some of them below.
Scenario 1: Convertible Notes from Family and/or Friends
It is not uncommon for entrepreneurs to raise funds from family and friends. If their investment is in the form of a convertible note, your friends and family can be the true losers of the deal.
Essentially, your friends and family give you a lot of money (probably reluctantly) and take an incredible amount of risk on a company that primarily consists of vague ideas and maybe a prototype. According to the terms of the deal, you give them a 15% discount based on the valuation set at the next round of funding. During your next round, which may be from an angel investor, the valuation is set, and your friends/family end up paying almost the same valuation as the angel even though they took a much larger risk than the angel. Sure, they still receive the 15% discount, but that doesn’t reflect the risk they took by investing in you in the past.
Scenario 2: Convertible Notes from Angel Investors or VC Funds
In this scenario, you are dealing with sophisticated investors. They are going to introduce a new element to the convertible note — the cap.
What is a cap?
A cap creates a maximum pre-money valuation for the next round of funding; for example, let’s say $2,000,000. As a result, an investor giving you $500,000 should expect to own no less than 20% of your company for the $500,000 investment ($500,000/($2,000,000+$500,000).
However, there is no minimum in this deal! If your next round is raised at a valuation that is less than the maximum cap, the same $500,000 can buy a much larger portion of your company! Yikes.
A cap in a convertible note can be devastating to an entrepreneur.
What if you do not want a cap? Well, a convertible note without a cap is not a smart move for investors, but you are more than welcome to try to convince investors to exclude it from the deal.
Bottom Line
This purpose of this story is not to tell you that convertible notes are bad. I have simply seen too many entrepreneurs accept convertible notes without understanding them, and I wanted to showcase a couple of scenarios involving convertible notes. Additionally, this is not a comprehensive post about convertible notes, either. They get much, much more complex.
If you understood all of this information about convertible notes prior to reading this, continue doing your research, and you will be fine. If not, I urge you to take a step back and ensure that you comprehend the terms of convertible notes before you make a decision today that you may regret in the future.
