Should Entrepreneurs Be Worried About Convertible Notes as a First Financing Event?

Q:  I am looking to raise some money around an early stage business opportunity and have been instructed to raise a convertible note before doing a Series A round.

The VCs providing the convertible note would give a handshake deal to continue onto the A round should milestones be met…

Is this smart? Or should one stay away from convertible notes?

A:  (Jason)  If the VC is reputable, then you are probably okay.  We’ve done many seed / pre-Series A deals with a convertible note structure.  Other firms, like Charles River Ventures, do as well.  Let’s look at the pros and cons.

Pros:  It is much cheaper to consummate a note deal, than a financing deal, which also means it is much quicker to close.  Also, you don’t have to lock in a very low valuation today and if you do well the notes should convert into a higher valuation than they would have if you have done an equity deal.  Other cons include that you can rid yourself of the investor (if you don’t like him later) by buying out his notes – assuming you have another funder.

Cons:  Debt holders have rights that equity holders don’t – namely they can call their loan and request their money back.  This means that essentially they can shut you down if you don’t have the cash to pay them and they want out (subject, of course to the deal that you negotiate).

Make sure that the convertible notes convert automatically (not at the discretion of the VC) should the company consummate a Series A round, so that regardless if this VC is in for the long haul, anyone who funds the company can convert the original note holders to equity.

  • Vineet

    Jason, Aren’t there also issues that VCs since they don’t haven an equity stake have a vested interest in driving down the value of the next (Series A) round? Is there any way to get around this?

  • Jason

    I get the point, but doubt it would happen in real life. Stunting the company in the beginning isn’t going to help long run return values and that is what the VC is really playing for. Besides, the VC isn’t running the company, so it’s hard to see how they would control this dynamic. Again, assuming they are on the up and up, they will want to see the company succeed and have an “in” into the financing via their note.

  • It can differ by geography, but I’d say that convertible notes are the exception for institutional rounds; whereas they are quite common for angel rounds.
    Unless deal speed is critical or there is a huge gap in valuation expectations, VCs aren’t interested in their dollars converting into a valuation their dollars helped create. Unless the VC goes there, I wouldn’t spend too many cycles trying to go debt instead of equity. You want everyone aligned and equity does that best.
    Angels can differ widely, however, and if they will accept convertible debt it might be worthwhile. It avoids the valuation dance with an angel and the risk that such a dance results in a valuation that will create problems for the next round. Of course, they may have the same concern as VCs (e.g. their dollars working against their conversion valuation), but not as often.
    If it’s a close call, I’d err toward solutions that keep everyone aligned…

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  • Brian

    You mentioned “Other cons include that you can rid yourself of the investor (if you don’t like him later) by buying out his notes – assuming you have another funder.” but do you mean to say other PROS instead of CONS?