Is there an entrepreneur willing to say "Yep, tried them, got bitten in the hindquarters", even anonymously? I don't necessarily disbelieve here but it strikes me that VCs have the curious property of always giving fundraising advice which is in the interest of VCs. I acknowledge that somewhere in this wide world there may actually be a VC motivated primarily by friends-and-family getting appropriate compensation for risky investments but that is not the way I will bet.
My understanding -- limited, in that I've been a party to two but from the other side of the table -- is that a major reason they became popular is because they take the fangs out of collusive behavior by investors. The Valley had evolved a "Well, I'll invest if you get a lead" "Well, I'll lead if you close $X" system which froze out a lot of companies if the founders didn't have deep, pre-existing social networks. "You want a lead!" sounds a lot like wistful nostalgia for this gatekeeping behavior. I understand why a gatekeeper would see it that way. I don't understand why the gated would.
I totally get why i would be seen as biased. I have given this advice hundreds of times in small sessions verbally and I REALLY have no interest in driving my point of view for me. I do 2 deals a year. It barely matters to me personally.
Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s. I promise you you'll hear similar views to mine. Also, ask some very smart lawyers for a balanced view. I think you'll mostly hear the same.
re: gate keeper protecting the establishment. I know you don't know me but truthfully it is nothing of the sort. I think in simple life lessons. When you matter more to a small set of people they have more interest in helping you in tough times. If you never make mistakes or struggle then the argument of not having strong leads makes sense. It's just that this is the edge case.
Thank you for your reply on HN. Can you also please reply to grellas's post (at or near the top)? grellas is a "very smart lawyer" who posted some excellent counter-points to your original article. Personally, I'd love to hear your response.
I think grella said the advantages of convertible notes are:
1. First note is capped but later notes can be uncapped;
2. Fewer tax risks;
3. Doesn't mess up your equity pricing;
4. You can do a number of notes with different amounts raised;
5. You don't give your investors the kind of protections they would get in equity rounds.
I'd like to hear Mark's reply too. My opinion below.
I tend to think that all of these things (aside from the tax risks) are either inconsequential in comparison to equity financing (3, 4), or simply the result of having unsophisticated or uncaring investors (1, 5). The tax risks he did not explain; I assume he means the risk that the IRS would use an equity round to peg a value on shares or options given to employees that differs from what the company assumed. If so, this risk exists no matter what.
I agree that giving the investors less protective provisions or uncapped notes is better for the company. If you can get investors to agree to that, good for you, but that's separate from structure.
The primary problem with convertible notes as they are used today for entrepreneurs is that the investor gets the lower of the cap or a discount to the next round. This optionality is paid for by the entrepreneur. And while, as grella points out, the cost of this optionality is usually pretty low, so is the value of the benefits he points out.
I don't understand your "going back to the mid-90s" point.
I cofounded a company that was VC-funded in the late 90s, after having principal roles in two successful bootstrapped companies in the mid-90s.
What I don't understand about the point you're trying to make:
* Modern convertible debt financing of the form we're discussing --- unpriced rounds, rolling closes --- were not available in the 1990s.
* Entrepreneurs who fit the cohort you're implicitly defining --- people who raised VC in the 90s --- are effectively immune to the effect Patrick is describing. Executing a first VC-funded company well gets you your next VC-funded company. Nobody disputes that the priced-round VC system worked well for proven operators. The subtextual argument for convertible debt is that without it, you might not get the next Airbnb or Dropbox --- companies that barely even made it into YC.
Everyone else has covered the more substantive issues, but on your point about lawyers - as far as I can tell, there is nothing close to a consensus amongst top startup attorneys that convertible notes are a bad idea.
Part of this is that good startup attorneys can help their clients avoid most of the issues you discuss - i.e. explaining what the terms mean, explaining that discount-only notes are relatively uncommon, explaining what happens when you raise an equity round at a valuation less than the valuation cap, adding in provisions to prevent liquidity preference double-dipping, etc.
I think you are right - having a lead is very valuable - but you're also missing the other side of the argument.
Convertible notes have upsides, primarily that they give the entrepreneur significantly more leverage in a seed round. The benefits for entrepreneurs have been pretty clear in the last decade: lower dilution and much better terms.
So it strikes me that while there are certainly downsides to notes, I don't see the major upside addressed in your piece. This is what makes it seem a little self-serving, IMO, esp since the upsides you do address come across a little bit like strawmen.
I think the point of the article is that they don't give the entrepreneur more leverage. I don't think that there is a correlation between convertible note seed financings and rising valuations: valuations are rising for all types of financings over the last five years.
The downside to a note is exactly this: the cap in the note is the valuation an investor would pay. That is how I view it, as an investor. And when the next round is lower than the cap, it usually means the company is busted somehow. I am completely indifferent, as an investor, to a convertible note or equity because the outcome is generally the same for me. The reason I hate notes generally has to do with the negotiations around them (what's the term, what happens if the company gets acquired before the A, what happens if the other angels get pissy and try to claim that the company is in default, do I have pro-rata rights in the next round, etc.)
But my biggest fear with convertible notes is what the Series A VCs are going to do to me, the angel investor. They could generally not give a damn about me and since the company already has my money, I have no negotiating leverage if they decide to do anything aggressive. With an equity deal, I know what I have and, since it's very similar to what the founders have (common stock) it's hard to screw me without screwing the founders.
I'd like to know what you consider the upside of convertible notes, or how they give the entrepreneur leverage, because I just don't see them.
At a seed stage, the major cause of rising valuations is the massive competition for good deals. This is caused by the massive proliferation of angel investors. This is caused by simpler financings, including convertible notes.
Where does the entrepreneur get leverage? So many ways:
- small angel investors cant afford to spend a large amount on lawyers, so simple legal terms are enablers
- rolling closes are massive enablers. They mean you don't need a lead. Which means there isn't anyone with leverage. Which means if anyone thinks the price is too high they can drop out without affecting the price from the other investors. In fact, since you'll have cash in the bank from half your investors, you can raise with the financial pressure off, and demand a higher price from other investors.
- cheap legal fees allow smaller rounds (even a cheap priced round is 15-25k; our bill came to 42k). You can raise 100k in a weekend with no extra costs.
The massive proliferation of angels is not due to simpler documents. The massive proliferation of angels is due to the smaller amounts raised in seed rounds.
It's just as easy to use template equity financing docs as template debt financing docs. I'm not sure where this alleged complexity comes from. There is no intrinsic complexity of equity docs that doesn't exist for debt docs. I've negotiated debt docs (for real loans to companies further along that were far, far more complicated than any equity docs you've ever seen. Because having more than one type of financing in a company adds intrinsic complexity (because the interests of different parties are no longer identical.) The reason convertible debt docs are simple is because no one cares enough to legally protect themselves. If you and the investor cared that little in putting together equity docs, the equity docs would be just as simple.
You can do a rolling close with equity. At least half the equity financings I've been involved with in the last ten years have had more than one close (my firm in the 90s tried to be the only one in the round, so there was only one close.) You can also do an equity round with no lead just as easily as a debt round. Why not? The reason most equity rounds have leads is because smart investors insist on leads and smart investors prefer equity. That's correlation, not causation.
I've done priced seed rounds for less than $10k. Series A and later are more expensive because there are more reps and warranties and checking of charters and etc.
If you were to raise Priced Seed Round, you will get a lower valuation than the cap. The Notes need to be structured right, I agree with Mark on this.
If you do not have a cap, you are screwing your investors = this is very bad. You should treat your investors well and with respect. They will help you to grow the company.
If you have a cap that is too high, it will look bad in later rounds. Set the cap with current market.
If you have any control, liquidation terms in your Note = this is insane. The whole point is not to negotiate these terms when your company is just getting started. The Note should convert into the future Preferred Stock with all the rights that will be negotiated later by the VCs on angel investors' behalf. This is only fair for angel investors.
The Convertible Notes can cause all sorts of problems, sure. But the biggest point is that taking money is never free. I don't think Convertible Notes will cause more problems that Priced Seed Rounds. I actually think they cause less problems. Witness YC financing = version of Convertible Notes.
I take as a given that people will make comments that are self serving unless I have info to the contrary. Not that you have to of course (good enough to just relay the information which is definitely helpful in many contexts obviously) but shows how possibly including a preface with what you said here could further strengthen what you are taking your valuable time to blog about. (Hey it's not like your posts are short, right? What's a few more words at the top?)
When selling someone (or negotiating) I always find it helpful when people make a critique such as the parent comment. Someone a while back made a critique according to how I price a particular consulting service [1]. As a result of that one comment I changed the way I priced so as not to give the appearance that I am not working in someone's best interest. (Because I was in my mind all along but once someone questioned it I made the change and it's worked better. Reason being it's a small part of how I make money and as you said "it barely matters to me personally". But the change was easy enough so why not?).
[1] "Why then is it in your best interest to get me the lowest price (I help buy things that are very expensive) if your compensation is at least partly dependent on the amount I pay for it?"
> Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s.
Entrepreneurs fitting these criteria are highly likely to be investors. Entrepreneurs today are part-time angels after fewer companies. If such an entrepreneur is giving advice they are likely to possess any bias investors are assumed to possess, that is, if their channel to the less experienced entrepreneur isn't already predicated on the potential for investment.
This would not be a good test for proving or disproving bias.
In addition to everything suggested here, I'm also very interested in understanding the following question:
how on earth are an investor and an early-stage entrepreneur supposed to come to a valuation number when the history of the company is pretty much non-existant and the projections of financials are a shot in the dark at best.
Sales and Faith. With a pre-revenue, pre-launch company, from the entrepreneur's side, it is pure sales. And from the investor's side, it is pure faith.
Build a good story, believe in it, and sell it. I can build a financial model with the best of them. But as Brad Feld once said about all early stage companies, "Your revenue forecast is wrong." You have to believe enough in yourself and your company to convince someone else to believe in you and back that up with cash.
It's a bet and always will be. And like any bet, some are more sure than others. But lots of "sure things" fail, and more than a few long-shots win and pay out big. Sales and Faith.
Mark - It's natural for us to assume people are "talking their book" when they give advice. (How many CEOs talk about "Working for passion" as an excuse to underpay?)
Thank you anyway for joining us here to share your contrarian view. If everyone agreed with each other, this would be a very boring place.
> Is there an entrepreneur willing to say "Yep, tried them, got bitten in the hindquarters",
Kinda, but in a different way. When we were raising our Series A round, some investors based their offer off our Seed round's valuation. One investor thought that our seed round was a capped note, and wrote us a term sheet that was a "generous increase over your cap" (I think 20% perhaps). I think if they had known the seed was a priced round, they would have made something more like a 100% increase over it's valuation.
Not exactly what you're asking for, but I did a priced first round because my investors insisted on it and believe it helped me a great deal more than a convertible note would've.
In particular, what Suster says about the importance of having a lead rings absolutely true to me. My investors were a huge help when figuring out a complicated merger that eventually led to a terrific outcome. If I had raised from a big bunch of smaller, not-particularly-invested angels instead - well, who's to say, but I suspect I would've botched it.
Not entirely related but to the point of Mark's 'bias'. I had a meeting with him many years ago when he just got started at GRP. Despite his very clear 'No' to our pitch, he gave some of the best, and direct, advice I received and nearly 5 years later it is still serving me well. It allowed me to do what I wanted without needing to raise money at that point. Of course that makes me biased towards his post so take my opinion with a grain of salt :)
That said, Mark seems one of the guys that really likes to help entrepreneurs. I read his post not as "Don't ever do a note" but "be very aware of unintended consequences". As I am starting to fundraise for a new company, I've felt incredibly uncomfortable with convertible notes for the reasons Mark outlined in his post. I thought I was being paranoid since everybody is saying notes are the way to go, so it is nice to read an opposing view.
One major problem with convertible debt in that it is fundamentally debt with an X year term and Y% interest rate. If the startup chooses not to raise further capital, the note does not dictate what is done (at least ours didn't).
This isn't much of a problem if your investors are really nice, smart people. But if they aren't...
I've had the experience of a non-entrepreneur-friendly investor calling the debt (e.g. demanding repayment after the term had expired) at a time when our startup couldn't make a payment of that size. They refused to extend the term. The investor then threatened to liquidate the company if we didn't pay them back.
Some of my cofounders had made money in the past, so we repaid the debt by having them lend money to the company. But I'm not sure what we would have done if we didn't have that option.
It's better for noteholders for the conversion price to be as low as possible. I'm sure this creates bad behavior. I've certainly felt badly about deals that went against me, though I haven't done anything.
My understanding -- limited, in that I've been a party to two but from the other side of the table -- is that a major reason they became popular is because they take the fangs out of collusive behavior by investors. The Valley had evolved a "Well, I'll invest if you get a lead" "Well, I'll lead if you close $X" system which froze out a lot of companies if the founders didn't have deep, pre-existing social networks. "You want a lead!" sounds a lot like wistful nostalgia for this gatekeeping behavior. I understand why a gatekeeper would see it that way. I don't understand why the gated would.