Convertible Notes- The Phillips Screwdriver of Startup Financing Instruments

Contrary to what you might think, convertible notes have been around for a long time in early stage tech financing. What’s different today is that Y Combinator popularized it several years ago and since then, we’ve seen seed stage funding explode so these financial instruments have become pretty pervasive.

The problem these days is that there is lots of confusion and uncertainty when using them:

What percentage of the company am I buying?
What happens when you sell before a conversion event?
Does the note convert pre-money or post-money?

On the last question, see Brad Feld’s recent post:

We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on a pre-money or a post-money basis. This can be especially confusing, and ambiguous, when there are multiple price caps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.

With all this confusion, convertible notes seem like a pretty shitty de facto standard, if you ask me. Would you believe me if I told you things weren’t always this way? Once upon a time, there was more agreement and consistency when using convertible notes.

Here’s Seth Levine (Brad Feld’s partner) talking about convertibles converting pre-money in 2012:

The problem, of course, is that their convert is already a part of their capitalization – even though it’s not reflected on the cap table…

(in one case the entrepreneurs viewed the convert as a post equity deal event, meaning that they thought they were negotiating a round with us that would then layer on the debt conversion – exactly the opposite of how it actually works!).

When you raise $2M on a convert with a $6M cap you’ve sold 25% of your company (at least; 25% if this converts at the cap). And while your cap table may not yet reflect this in the numbers, your 40% founders equity stake is actually already 30% when you start the process of raising your equity round.

And here’s Babak Nivi on Venture Hacks (which leans founder friendly) saying the same thing (in a Youtube video on cap tables in 2008):

Your $6M pre-money valuation unfortunately includes the seed debt…

So we’ve gone from a time where we generally agreed to do something a certain way to a time where there’s lots of disagreement on how to do something.  It’s just a reality of where we are in this cycle and it’s a tough coordination problem to address with a market-based solution.

The complaints about notes are at an elevated level these days and there are a lot of investors who are shying away from them, for valid reasons (see Joanne Wilson).  However, we’re still seeing a lot of founders favoring them over equity or SAFE-style docs (and their choice is partly a function of what they think will work best for them in the fundraising marketplace).

De facto standards emerge when there is mutual gain in coordinating. When there’s a critical mass of founders, investors, and service providers using the same standards, it’s a beautiful thing (they are hard to establish and in my opinion, really under-appreciated!). But they are also difficult to replace when there’s something newer and better.

So just like the QWERTY keyboard, life goes on for convertible notes.  It may not be the perfect tool for pre-seed/seed stage financing, but it’s something that everyone in the game has in their toolbox.

 

Posted by John Ryu, Partner at Scout Ventures

Convertible Notes- The Phillips Screwdriver of Startup Financing Instruments

Trends Move Fast In Venture

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I recently found some old browser bookmarks from about a year ago and clicked to see what they were about. They were all articles about firms focusing on “post-seed” stage investments– a stage that became relevant and potentially valuable because of a funding gap caused by the Series A Crunch.

Fast forward to March 2015 and the thing that’s all the rage in venture capital these days is “pre-seed” stage investing.  The rationale is that seed has gotten so big that now there is a funding gap between angel and seed investors.  One thing’s for sure is that capital is liquid in the early stages and it flows into all the high potential spaces and crevices it can find.

In the startup and venture capital world, things happen so fast that a year’s time can provide a fun look back to see how things were different compared to today.

 

 

Trends Move Fast In Venture