Perspectives on entrepreneurship, startups and venture capital from K9 Ventures.

Thoughts on Convertible Notes

Tweet about this on TwitterShare on FacebookShare on LinkedInShare on Google+Email this to someone

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.

The bridge to the Pacific ocean

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.

You can follow me on Twitter at @ManuKumar, or, follow @K9Ventures for just the K9 Ventures related tweets.

  • Pingback: What is convertible equity (or a convertible security)? | MyWebspace()

  • raghav kheria

    Hi Manu,

    Very insightful article, especially for people new into this game. Have you written similar articles about other methods of financing such as preferred equity?

    Thank you very much.


  • Pingback: Everything You Ever Wanted To Know About Convertible Note Seed Financings (But Were Afraid To Ask) - Success Strategy()

  • oconn92234

    Being more on the entrepreneur side I don’t know near enought about the VC side so Manu great post indeed. We here in Europe are so far behine you guys it is nearly embarrising so thanks for making the convertible notes thing at least more clear for me

  • Pingback: Quora()

  • Pingback: Das Ende des Wandeldarlehens()

  • Pingback: Roy Firestein » Seed Funding – Some New Considerations()

  • Pingback: » Seed Funding – Some New Considerations | StartupNorth()

  • cwall

    Hi Manu,

    Are you seeing warrants attached to the notes?

  • BrandonCWhite

    Hi Manu,

    Great read, thanks for taking the time to put it together.

  • tydanco

    Bravo. Well said.

  • mtanne

    Manu, great post on a topic entrepreneurs and investors need to understand better. Convertible notes are being used much more than their original purpose intended. The evolution was less driven by closing costs, and more because angel investors were reluctant to value the company without an institutional investor. Angels were unsophisticated and risked overpaying, and VCs preferred to be the ones to establish the price. The emergence of sophisticated angels and increase in angel funding has brought what was an occasional occurrence to the forefront.

    Most of the factors you’ve raised – board composition, pro-rata rights, etc. – are issues if founders are thinking “should we do a note vs. do a round?” Notes should be thought of as temporary instruments, not as a viable long term financing strategy. A better approach would be: “should we start with a group of angels to prove out the idea before approaching institutional investors? And if so, should we set the value now, or do a note?”

    A note without a cap on valuation creates mis-alignment as you’ve pointed out. Alignment of interest is a critical component of the investor-founder relationship. If there is sufficient depth in the angel investors, price a round. If venture capital will be needed soon, then do a note to get some cash in the bank. The discount and valuation cap not only protect the investor from a increased valuation which they presumably helped to occur, but are a return for investing early and presumably helping reduce risk between the note and the financing, for which 20% is not unreasonable.

    But in addition to a valuation cap, it’s essential to clearly define what will happen if you don’t raise additional equity, or if the company gets acquired before closing a round. And yes, the capital gains clock doesn’t start until you convert to equity.

    Notes are a favorable instrument if you need a small amount of capital, aren’t prepared to go to institutional investors, or need some progress before you’ll know a fair valuation. This is a great discussion we should all be having.

  • manukumar

    Adeo Ressi from the Founder’s Institute/The Funded pointed me to his recent blog post on convertible notes at

    Adeo’s post presents some interesting data on the use of notes and so I wanted to provide a link to it here for additional reading on this topic.

    If you know of other good posts or discussion on this topic, please feel free to post them in the comments here.

  • manukumar

    Adeo Ressi from the Founder’s Institute/The Funded pointed me to his recent blog post on convertible notes at . Adeo’s post presents some interesting data on the use of notes, and so I wanted to provide a link to it here for additional reading on this topic.

    If you know of other good posts or discussion ont his topic, please feel free to post them in the comments here.

  • JennaTest

    test 1, will delete

  • ScottEdWalker

    @nivi Solid comments, Nivi. Series Seed docs are not a panacea. Indeed, if as much time were spent drafting form convertible notes, the legal fees would be 20% of the fees for Series Seed. Moreover, having an investor sit on a Board for a small seed investment makes no sense (and only distracts the startup). As Fred Wilson has argued, sometimes investors can provide the most value by just providing capital and not “meddling.” Finally, you need to check with the tax guys whether the holding period of the note is tacked to some or all of the shares upon conversion. Thanks, Scott (@ScottEdWalker)

  • nivi

    I’m very glad you wrote this. I’m especially glad you describe the history of the convertible note.

    Notes were good technology a few years ago but now there are better technologies like Series Seed that have many of the benefits of debt (speed, simplicity, less negotiation). And debt is pretty complicated when you really look at it. I’m guessing we’ll be back to equity in a couple years, for the better. But Series Seed and other equity docs need to be tested a bit more too.

    1. Disagree on the misalignment on incentives. The Venture Hacks articles on debt are somewhat dated at this point, but describes the reasons why I disagree on this point.

    2. You can work around this in two ways. The company can’t pay back the debt and it converts to equity at maturity. I always include these in debt agreements.

    3. I think people need to put more thought into whether a board makes sense for a company, especially at the early stages. I generally agree with Andreessen’s claim that “in many cases, we don’t even think today’s raw startups should have boards” (

    4. Agreed, debt math is too complicated.

    5. Agreed that investors should get long-term cap gains too.

  • sidviswanathan

    Great post Manu! Wanted to ask a question about the discount amount and the maturity dates? What are typical ranges you are seeing in convertible note deals for these?

  • berolz

    Thanks for the post – one point of clarification on the tax implications. Could you share more details on this? The guidance I’ve received is that they’re still treated as long-term cap gains:

    Federal Tax Coordinator 2d ¶I-8925. Stock acquired by exercise of “conversion rights.” If a cash payment is required for the conversion of debentures into stock of the corporation, the holding period of each share of stock acquired on the conversion is split. Part of the share is allocated to the bond exchange, and the holding period for that portion includes the holding period of the converted debenture. The balance of the share is allocated to the cash payment, and its holding period starts with the date following the date when the stock was acquired by the conversion. Allocation is made by attributing to the cash the ratio the cash payment per share bore to the market value of the share on the conversion date, and attributing the rest to the bond. 16

  • Markis

    Excellent blog post on convertible notes

  • PeterWerner

    Manu – thanks for the thoughtful post. The strong support YC and others have shown for using convertible notes in seed rounds has definitely led to broad-based support for them. There are significant efficiencies associated with the use of notes in the context of making a bunch of small investments simultaneously in a “graduating class” (fewer custom terms as compared to a seed equity round, which means a bunch less time spent, in the aggregate, across the class), but those efficiencies aren’t as important when looking at this on a single-investment basis. And when the lawyers involved are experienced and focused on the business outcomes and on the few terms that really matter in a seed round, there’s probably not a huge difference in cost or execution time between an equity round and a convertible debt round (at least not enough of a difference for it to drive the form of investment). So I’m with you in believing that convertible notes are not obviously superior to equity for a seed round.

    One important piece of this that some of my company clients spend a lot of time trying to evaluate in determining whether notes make sense (and that you and Yokum touch on) is the conversion cap and its uncertain effect on the cap table following the equity financing in which the notes convert. Particularly with the frothy valuations we’re seeing, it’s very hard to set a conversion cap that both sides believe to be “fair.” The potential for a valuation in the next round that far exceeds the cap leads some of my clients towards doing an equity seed round and suffering the added dilution (though it’s arguable whether that’s the case) in favor of increased certainty. And the last thing that companies or investors want is an investor in the next financing conditioning its investment on the company renegotiating the cap, or having the pre-money stockholders bear a significant portion of the dilution resulting from the low cap. (that dynamic doesn’t happen too often, but it’s something I’ve seen founders be sensitive to).

    Your point about working with a board is important. See the multitude of blog posts and other resources about building the right board, etc. Even with a notes round, a founding team should consider building out a “real” board. And because investors normally don’t expect to have a board seat in connection with investing in convertible notes, the company may have more flexibility in strategically building a board, adding an industry expert or other high quality outsider, etc. In addition to learning how to work with a board, many founding teams can benefit from the connections, the “adult supervision” and the added discipline that comes with having a (good) board.

    You didn’t ask, but….one personal pet peeve of mine is the “liquidation multiple” built into some notes, in which if the company is acquired while the note is outstanding, the noteholders get 2x (or more) in return. Most seed equity doesn’t have more than a 1x multiple “off the top,” so why should notes? Allow the notes to convert to common, or get paid off at the close, which roughly approximates the treatment of non-participating preferred. This one definitely has its genesis in high-risk bridge notes in more mature (and more troubled) companies, in which the added risk taken by the investor arguably merits the added potential return.

    A few additional thoughts on the “unintended consequences” of convertible notes:

    1. It’s not obvious to me that a conversion cap, even a very low one, is a bad thing in and of itself. It’s just bad if both sides don’t understand the consequences.

    2. As a follow-on to #1, companies should avoid (or at least take the time to understand the effect of) a cap coupled with a conversion discount. Structure with one or the other, or structure so that the discount is only in effect upon a conversion at a valuation below the cap.

    3. Don’t forget interest. Accumulated interest that converts at a financing is effectively an additional discount (in very rough numbers, a note with 10% interest that converts after being outstanding for a year has roughly the same “discount” effect as a 10% conversion discount).


  • altgate

    @altgate An old post on “5 reasons convertible debt sucks”:

  • IanSimp

    Thank you so much for writing this. I’m struggling with this issue right now, trying to decide between offering convertible debt or equity. It’s a really tough problem and I’m learning a ton as an entrepreneur just by the process of weighing the pros and cons. You’ve given me a lot to think about, and I’m grateful for that.

  • dh

    What a great post. As a newer type of financing for most entrepreneurs it can be dangerous to not understand it.

  • RyanSwagar

    Manu – Excellent post and completely agree with you on all points !!

  • SethElliott


    Firstly, let me say that this is an excellent post – particularly placing the convertible note in proper historical context and highlighting a number of key elements of possible concern. On the whole, I find that

    A number of the points I wish to make have been touched upon by Yokum, so I’ll try not to be repetitive.

    Incentive Alignment. There’s no question that the potential for abuse as a result of different incentives certainly exists. However, I agree with Yokum that this is unlikely to be a practical problem in the near future. Angel investors of today are not generally seeking to manipulate follow-on financings in order to take advantage of next-round valuations. Nonetheless, I think this point can be placed in the “to-watch” category. As more money (from more sources) pours into early stage transactions – and as more time passes – this could prove to be a more present concern. I recall the “toxic-convertible” PIPE structures from years past – in the early stages these were designed simply to protect investors – as time passed, certain nefarious characters began to use these instruments actively to the detriment of companies.

    Maturity & Commitment. There’s no question that Convertible Notes provide a “doomsday” measure of protection for the investor – the ability to force repayment or liquidation. Given the size of these investments and the stage of life of these companies, I think that the risk of “calling” the note is quite small in practical terms. I’m assuming that most convertible note structures in today’s world involve 36-60 month terms (some I have seen at 24). For pre-seed to seed level investing, that’s a near eternity. If the maturity date roles around and an additional financing (or lack of need for such) has not arrived, I think we might generally agree that the company probably “deserves” to have investors demanding a repayment of the notes. Your comment about the Social Proof of perceived commitment is a bit more difficult. It seems to me that the widespread acceptance of the Convertible Note structure has removed the former taint that would accompany these instruments in the past – but I’ve not explored the issue directly enough to claim this as fact.

    Board. Like Yokum, I’m not sure I agree that most Founders choose the Convertible Note structure in order to avoid investor Board representation. I think it’s more the case that the Convertible Note is used because it’s cheaper/faster/easier – as well as now becoming a ubiquitous structure. This doesn’t mean that your point about the value of learning to manage a Board is invalid – quite the contrary. I think, however, that it is not core to the Convertible Note issue itself.

    Conversion Mathematics. Your commentary on the mathematics of conversion (and Yokum’s) is incredibly significant and important. Just like any investment instrument, it is incumbent upon an entrepreneur (or investor) to examine scenarios and understand the ramifications. My only comment is that in of itself, this doesn’t play into the decision about using a Convertible Note – it simply highlights the importance of understanding and negotiating the cap component of the instrument – no different than negotiating the rights/preferences of an equity instrument.

    Capital Gains. This is an absolutely critical point for investors. Utilizing a Convertible Note structure has incontrovertible negative implications when it comes to future liquidity and tax considerations. This is, in fact, the yang to the yin of your point 3 (debt instrument preference). I echo Yokum’s emphasis on your point about qualified small business stock, though in many cases I suspect that the liquidity event may occur before 5 years elapse (which doesn’t abrogate the core issue of ordinary income vs. capital gains – and as Yokum points out you can roll this into another qualified investment if you are a regular investor).

    I think you’ve done a fantastic job of elucidating some of the issues to be examined in regards to regular use of the Convertible Note structure. As you say, the “notes have done their job… they helped everyone realize that startup financing needs to become easier, faster and cheaper — and it has.” If, in fact, the mechanistic process of early stage investing using equity instruments continues to improve, then I would agree that the need for the Convertible Note structure becomes far less important.

    Thanks again for a great post!


  • altgate

    I’ve thought the same for a long time. Converts allow both the investor and the founder to be lazy. When everyone gets lazy bad things happen.

  • Yokum

    Hi Manu,

    I’m glad that you finally got around to finishing this post. Very well thought through. I don’t necessarily agree with the ordering/importance of the points that you make, but I think that the following points are most important.

    1. Zero percent capital gain on qualified small business stock is a REALLY good reason for angel investors to prefer equity financings. (Please note that the QSBS rollover provisions will allow gain to be deferred if the proceeds from a liquidity event are reinvested into other QSBS within 60 days even if the 5 year period has not been met.)

    2. Giving away more liquidation preference than amount invested is a REALLY good reason for founders to tweak convertible debt terms (to pay conversion discounts in common stock) or do equity financings instead.

    3. The primary reason that convertible debt has become so popular the last couple of years is because lawyers (like me) have pushed convertible debt as quicker and cheaper than an equity financing.

    I think that part of the analysis suffers from a bit of a “straw man” fallacy.

    1. While I think there is a misalignment issue (point 1 above), I don’t think as a practical matter that angel investors would collude with VCs to drive Series A valuations down in order to benefit uncapped convertible debt holders.

    2. In addition, I don’t think that there is that great of a problem with convertible debt maturing and angel investors forcing bankruptcy upon early-stage start up companies (point 2 above). (Please note that Adeo Ressi has made the same point as you recently. )

    3. I’m not sure that founders really prefer to do convertible debt in order to avoid giving away board seats (point 3) and other rights. I simply think that angel investors don’t really think to ask for board seats and other rights (such as vetos on a sale of company, etc.) as they don’t care — or they trust the founders to do the right thing. I have seen convertible debt deals where extremely sophisticated early-stage investors load up convertible debts with protective provisions, pro rata rights, board seats, etc.