Jun 13 2007 by Jason

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.