Here in 2014 convertible notes seem to be all the rage in the startup funding arena. The commonly given reasons for using notes versus a straight equity funding arrangement are: faster to close, cheaper to close, and it pushes back the valuation discussion. There are other advantages to notes but these are the most common reasons I heard from founders when they present a term sheet reflecting a convertible note.
From an investor standpoint though, I don’t love convertible note terms. Yes, specifically the “terms”. I don’t dislike convertible notes overall, but they way they are proposed by founders often don’t make sense for the investor.
Term sheets with convertible notes are for a specific amount the founder(s) want to raise, a term (I often 18-24 months), and usually a “cap” on the conversion value and a discount to the next round of funding. I’m not going to go through the structure of a note because there are plenty of resources to cover that. I’ll assume you’re already familiar with them and the various parts commonly negotiated.
But, here are some challenges with this model. If you are raising money using a note it is almost always the first round of fundraising (seed series) – and it’s the riskiest point at which an investment will be made. The valuation of the venture today – pre-investment – is much lower* than it will be post-investment, especially at the second round if it is 18-24 months in the future. (*Unless the founders mess up on the execution, which does happen about 50% of the time.)
What the founders often want to set as the cap on the note is the value they expect post-money and closer to the value at the timing of the second funding round. They don’t want to let go of too much equity or “taint” the future value by setting a cap that might be lower than a realistic potential value for the conversion-triggering round.
The problem is that the angel/seed investors are taking a huge risk. So for them to invest via a note with anything longer than perhaps a six-month term, they’re buying in today at a conversion value that is much higher later. And the discount (generally 5-30%) doesn’t offset enough of the risk. By the time a company closes on a second round of funding they’re much further along to success and have a lower risk profile.
For this reason I see a lot of angels actually waiting and investing on A rounds versus Seed rounds. They wait and remove a lot of the initial risk of quick failure. When they invest in the A round they might pay 20% (or whatever discount is agreed) more than the Seed investors but that difference in pricing for an investment that will likely take five or more years to produce a gain, and at a point where almost half of ventures fail (many fail fast – before an A round), the risk-reward analysis makes sense for them to wait. But if most investors wait until the A round, it makes it way harder for founders to raise money in a Seed round.
What’s the solution? Well, a convertible note with a really short term – like 6 months – so that the value at the investment time and the value at the conversion time are fairly close, makes more sense. In that note (well, in all notes really) the cap should be something reasonable and fair for the value of the company today. Because of the shortened term, that value should hold true if properly negotiated in the first place.
Another “solution” is just to avoid a note and do a straight equity funding round. You still need to make sure the valuation analysis is handled well, but at least you can deal with “now” and not worry about future-raise valuations, and cost-of-capital with terms, etc.
Founders: I’ve had this discussion with a number of founders raising money, and I’m not sure if I properly communicated the investor standpoint concern in this post, but please take the time to try to understand things from the investor side. You want a win-win with your investors. This is a long-term relationship and it’s not just money but also guidance, contacts, future funding help, etc. involved in deals.
The potential reward for those very first super-risky investments needs to be worth it for those first people who trust in you, support in your vision, and believe in your ability to execute. Please be reasonable. I think you’ll find that closing a funding round will be much easier and faster, and the relationship with your investors will be that much better.