Convertible Notes Explained

There's a lot of blog posts out there about why startups shouldn't use convertible notes to raise capital.  

Some people really don't like convertibles (like Union Square Ventures partner, Fred Wilson), others lump them in with Bridge Loans, still more position them as something you should hold at arm's length while moving swiftly towards the trash can.

The main arguments against convertibles are: companies shouldn't incur large amounts of debt when they are just starting out; it's better to hold equity and act like a shareholder; investors have too much power over the founders if they hold a note, etc, etc...

I don't think any of the arguments I've read hold water.  My position is: convertible loans should be the first thing that a startup considers. They are cheaper, offer the founders and investors protection in equal measure, offer the startup more flexibility (depending on how the mote is written), and enable the capital raising to be initiated and completed much faster than alternative approaches. 

What is a Convertible Note?

A convertible note is a (usually) simple contract that allows a startup to take money from an angel investor in the form of debt, and convert it into equity at a later time - for example, when the first VC puts money in the company.

Convertible notes usually have only a few terms:

  1. The amount of the loan to the company (e.g. US$100,000)
  2. The "trigger event" upon which the loan gets converted into shares in the company (e.g. the first venture capital round, or "Series A")
  3. The term of the loan repayment (e.g. two years)
  4. The interest rate (usually a nominal annual rate above LIBOR, say 5%)
  5. The "discount to the valuation" (the angel usually gets a 20% to 30% discount on the valuation established by the Series A guys - because they came in at a riskier time, and deserve some kind of reward for taking that risk.)

Other possible terms include a "valuation cap" (e.g. "$5,000,000) that states that if the company is valued above that amount by the incoming venture guys, the angel will not have to "pay" that valuation, but will instead will convert at the lower valuation of $5,000,000 - which is of course a great deal.

The best thing in my view about convertible notes is they allow a financing to get off the ground with a minimum of fuss.  I've seen (and written) convertible notes that were three pages long - about the length of a standard Series A term sheet.  When you're attempting to bring on board an extremely busy angel investor, the less paperwork - and the more protection you can offer - the better.  Convertibles rock, in that regard.    

So in closing, let me be perfectly clear on my position: I love convertible notes for startups.  Here's the main reasons:

1. Startups are usually tight on cash - and convertibles are not expensive

The contracts themselves usually run no more than a few pages.  Virtually all of the hard stuff - the terms you find in the Shareholder Agreement, or Investor Rights Agreement, is absent - the thinking here is that this will be figured out by the professionals (e.g. first institutional money to be invested in the company) during the Series A round, and the guys buying the convertible note will simply fall in behind.

2. Startups usually have no idea of what their valuation is (or even will be) at the time of their first financing - and neither do the angels coming in

Convertible notes allow the valuation process to be kicked down the road to a point at which an investor with the kind of resources and experience to make a judgement call on this can do so.  At the point at which the startup accepts that valuation, the note holders can then convert (usually at a 20% to 30% discount), knowing that the valuation was set by an independent third party with good credentials.  This approach protects the founders from giving away too much equity too early (sorry, venture guys), and protects the investor by ensuring they get a fair deal down the road.

3. Convertible notes let you start raising money fast

If you - and your investors - are happy to do so, you can download an extremely professional form from the vast library published on Scribd (or use the embedded documents right here on Hatcher.)  You will need to engage a lawyer and have them check it through before you give it to an investor - but your costs will be minimal, perhaps a few thousand dollars max if there are changes to be made.  

4. Convertibles allow friends and family rounds to benefit from the insights of professional investors at the right time

The fact is, most startups raise money from Mom, Dad, Uncle Bill... or a group of friends in the business, from college, etc.  Let's assume these investors pass the "sophisticated investor" test - that doesn't mean they necessarily have the skills to figure out if your 3D printing/subspace agriculture project has a value of "$x".  The convertible structure allows the company to get traction sufficient to interest some professional investor groups, and allows your angels to benefit from their insights and valuation analysis.  

Disclaimer: I've raised money myself using convertible loans, and invested in startups using the same structure.  In the past few years, my experience has been that each time I've invested using a convertible loan, I've made money, and been very happy with the result.  Your experience may vary - but mine has been quite positive.

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John Sharp

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