There has been a lot of noise in the Valley lately about how most seed stage deals are now being done as convertible notes. In fact, PG from Y Combinator has proclaimed that that it is how things will be going forward. That might well be so, but I for one am not a fan of convertible notes. I may be well be in the minority in the Valley to think this way — especially so as a seed stage investor — but I have a strong preference for doing priced equity rounds for funding companies at any stage.
The convertible note was really intended as an instrument for a “bridge financing” — when an equity round was imminent, and likely to occur, but the company needed some money in between. In that case, it made good sense to have a debt instrument, where the note holder then converted into equity when the financing occurred. Since the financing would likely happen in short order, there was no need to have a valuation cap in the note. And if the financing didn’t happen, the debt nature of the instrument ensured that the note holders would be first in line to get their money back — even if it were by virtue of a liquidation of the company’s assets. For taking the risk of the financing not happening the note holder received a discount on the price of the round. In such a scenario, where the note is genuinely being used as bridge financing, a note makes perfect sense.
However, somewhere along the way, the usage of a convertible note changed. My guess is that this happened primarily because the legal fees associated with doing a priced/equity round were so ridiculous, and the process was so cumbersome (yes, blame the lawyers), that the convertible note came to be perceived as the easier, cheaper and faster option. Today, the convertible note is no longer a bridge, but has all too often become a pier.
Here are the reasons why I don’t like convertible notes:
1. An uncapped convertible note misaligns the incentives between the founders and the investors/note holders. The founders’ interest is to maximize the valuation of the company at the time of a follow-on financing, thereby minimizing founder dilution. However, the note holders’ motivation is to minimize the valuation of the company so that the dollars committed as part of their note convert in to as large a piece of the company as possible. In cases where the note holders are not going to have any influence on the follow-on financing (for example, 3F’s money) this is less of an issue. However, very often it is these early “investors” who make the introductions to the VCs who lead the follow-on round, and in that scenario, this mis-alignment of incentives is not good for the founders, or for the company. Obviously, both the founders and the note holders have the common objective of getting the company funded; but assuming the company is fundable, there is a basic misalignment of incentives when it comes to valuation.
The typical fix for this problem is to put in a cap in the note for the pre-money price for conversion. Before the era of capped notes, entrepreneurs preferred to do notes because the note essentially deferred the valuation of the company. However, once you put in a cap in a note, you’re effectively pricing the company. In fact, with a capped note, the note holders (at least on paper) are protected from a high valuation, but if the company raises money at a lower valuation, they still get their discount and get more of the company, i.e. it’s one-sided protection. The fact of the matter however is that The Golden Rule (He who has the gold, makes the rules) applies, and often when the company is raising follow-on-financing, the institutional investors will force the company to renegotiate the notes, often with adverse affects to the note holders — sometimes changing the cap or changing the discount. When it comes to choosing between founders and note holders, institutional investors will of course be more inclined to keep the founders happy (note: the same situation can arise with angels who own equity as well, but for some reason notes get messed with more than equity).
With some of the recent high cap notes that we have seen in 2010 and 2011, I predict that the mis-alignment of incentives will still be an issue in cases where those caps don’t kick in. This however remains to be seen, but will become apparent in the near future as some of the angel deals done in the form of notes with high pre-money price caps start to mature in the next 12-18 months.
2. Notes may have fewer rights associated with them, but they come with one big hammer. Legally, the note is still a debt instrument and can be called upon maturity. It is in essence equivalent to being a Liquidation Preference that is typically seen in a preferred equity financing. Practically, at least in the Valley, most investors think of notes as an investment, and don’t really expect that it will be paid back. However, the maturity date and the debt-nature of the note are often responsible for exerting pressure on founders that changes their focus from building value in the company, to instead “managing” the note holders and/or looking at doing a financing. In a lot of ways the note isn’t as strong a commitment from investors since they still have the option to pull their money out (if the note hasn’t converted before maturity) if they don’t like how the company is doing or how well it is executing. By contrast, when investors buy equity — they’re fully committed, they don’t have an option to get their money back (barring some ridiculous terms, which don’t really happen in the Valley) and their only choice is to help the company succeed or lose their money.
3. Founders often say that they prefer doing notes because they don’t want to deal with a Board of Directors, or the rights and preferences that come with an equity financing. It is true that most notes are lighter when it comes to rights and protective provisions for the investors — in fact with most notes there is no Board put into place, no information rights, no pro-rata rights, etc. In my opinion, founders who think this way are mistaken, and are missing out on an invaluable learning opportunity. Every first time founder needs to learn what it means to manage a board. If they don’t learn to do this, then when they raise money from institutional investors and have a formal Board of Directors put in place, they are ill-equipped to know what it means to have a board meeting, to prepare a board information packet, and most of all to manage the board (and yes, every board needs to be managed).
In the early stages of the company the Board of Directors need not be about “control”, but it does need to be about learning and about discipline. A *good* board member is *not* like a policeman, standing by to slap your wrists when you do something wrong. To the contrary, a *good* board (at least in the early stages) acts as the CEO’s personal shrink. It’s a tough tough job to be running a startup and you need to have people who are willing to listen, provide useful input, and sometimes a different point of view. Having a board meeting forces you to step back from the day to day fire-fighting and think about your company strategically. Where are you going? Is it in the right direction? That’s an invaluable exercise, which is probably even *more* important in the early stages of the company, while you’re still trying to figure out the technology, the product, the market, the pricing, the team. There are a lot of moving parts.
4. I am sometimes surprised at how many founders and investors don’t understand the mathematics of a note. There are multiple issues at hand here. Yokum from WSGR has an excellent blog post that describes how the how the conversion discount and price caps in a note result in the company creating more liquidation preference than the amount of the money that the note holders have invested. I’m not going to try and explain what Yokum has already explained in his post, but his point is well taken. If you have a choice between doing a priced round at the same valuation as what the cap would have been in a note, the company is actually better off doing the priced round than doing the note with a discount.
This problem is exacerbated even more by how few founders and angels understand what the cap and the discount really mean. Let’s try an example: Let’s say Shylock loans the company $100K on a convertible note with a pre-money cap of $1M or 20% discount (most notes use a lesser of type of language for this). Let’s say the company raises $1M ($900K in new money, plus the $100K for the note, just to keep the math simple) at a pre-money valuation of exactly $1M (assume at $1 per share) — same as the pre-money cap in the note. What percent of the company should the note holder get on conversion? If you think the answer is 5%, because the financing happened at the same pre-money valuation as the cap in the note, then you’re wrong. Given how most notes are worded the $1M pre-money valuation *doesn’t* trigger the cap because the share price by using the discount would be lower than the share price at the cap. The correct answer is that at a $1M pre-money valuation, the discounted share price for the note holder would be $0.80. So the number of share they would purchase for $100K (plus the interest, which I’m not factoring in here) is 125,000. So the actual percentage would work out to 6.17%. It’s not a big difference, but it’s important because most founders (and some investors) do not understand that in order for the discount to not kick in, the company must raise money at a valuation that is higher than the pre-money cap. Of course all of this is really dictated by how the note is structured; my example is based on what I’ve commonly seen.
5. Notes have some interesting ramifications for investors as well. When an investor buys equity in a priced round, the capital gains clock on that stock starts as of the date of investment. However, in the case of a note, and especially for notes with long maturity dates, the capital gains clock doesn’t start ticking till the the note converts. Now at the seed and angel level where a lot of startups make early exits, this can have a profound impact on the return to investors. Let’s say the the company is sold after one year. and it is a positive outcome. In the case of equity holders, they would have been in long-term capital gains and pay 15% on the gains. However, for a note holder, it’s likely that either they hadn’t converted yet, or if it had converted, it may not have been 1 year since the conversion. So now you’re paying 35% on the gains. You just gave away 20% to Uncle Sam? Why would you do that!?
In fact, under the current law, if you invest in a qualified small business stock in 2011, and hold that stock for 5 years, then the capital gains on the sale of that stock becomes 0%. Given that most companies that do make it big and go for the home run, on average will take longer than 5 years to exit, why would you want to be missing out on the opportunity to have the outcome be tax free (at least for federal taxes) as opposed to doing a note, and then waiting for it to convert. It baffles my mind that folks who are otherwise sophisticated investors would do notes in such a scenario.
The only argument in favor of notes that could still make sense is that notes are “easier, cheaper, and faster.” However, even that argument is becoming a much weaker one in the face of open-sourced financing documents like the Series Seed documents. I loved Ted Wang‘s post on why Series Seed documents are better than capped convertible notes. I, of course, agree whole heartedly with Ted. The notes have done their job… they helped everyone realize that startup financing needs to become easier, faster and cheaper — and it has. I’ve done priced equity rounds for companies at pre-negotiated amount with law firms on the basis of using standard docs at prices which are marginally more than it would have cost to do a note. And at the end of the process, everything is squeaky clean, well structured and sets the right tone for the startup to become a real company.
My purpose in writing this post is to incite a bigger discussion on this topic and to solicit more opinions and feedback. I accept that my view may be colored by the type of investing I do through K9 Ventures, where I only invest in 4-6 new companies a year, and I want to actively work with those companies. Given everything I’ve described above, I don’t see any reason to do a convertible note other than “that’s what everyone else is doing.” I never was one to follow the crowd, and so I’ve already been openly proclaiming to that “I don’t like notes.” But, I also like to keep an open mind and would love to hear from founders and from investors on their view on convertible notes.