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

How To Raise $20.5 Million The Signpost Way

This post was originally published on Brad’s personal blog at 

This month our longtime portfolio company, SignPost, humbly announced the close of their $20.5 million dollar Series C.

The Company offers consumer marketing tools and manages its customers’ presence on sites like Yelp, while leveraging data from credit card transactions and social media to send targeted marketing messages that drive sales, referrals and reviews.

For Scout, it is a proud day because Stu Wall was one of our first entrepreneurs when we launched Fund I.   We were originally introduced to Stu through another one of our entrepreneurs, Dan Gellert.   Dan is another great entrepreneur with a special place in Scout’s legacy, as he was one of my first board seats.   He sold his company GateGuru to TripAdvisor which enabled us to make our first LP distribution in Year 1 and gave us the credibility to raise more money.

As I reflect on how proud I am of both entrepreneurs and the journey I’ve experienced with them as an investor, I think its important to reflect on how we got here and how to replicate this relationship with more entrepreneurs.

(1) Our best deals are normally sourced through our entrepreneur network.   This is why its so important to always treat an entrepreneur with a level of mutual respect.

(2) When you get to meet an amazing entrepreneur, have the mindfulness to identify their potential and don’t be caught up in the day to day to miss the opportunity.

(3) Each and every relationships between an entrepreneur and investor is based on trust and communication.  Without these two key variables, its difficult to build a company that can win.

(4) As an investor, as soon as you find a kick ass entrepreneur don’t hesitate in helping them build and motivate their team.   No great entrepreneur can build an awesome company without a supportive and passionate team.  Stu asked me to talk to the entire Signpost team (now 213 strong!) the day before we announced to them the news of this raise.  I was inspired and I think the team was pretty fired up as well.

Building great companies is hard to do and it takes a really, really long time.

Don’t rush.

Value each entrepreneur and spend your time making a difference, not being a pain in the ass.

***This post is dedicated to the memory of a new and dear friend.  All of our hearts are a little less full tonight.  We love you Kelsey.***

How To Raise $20.5 Million The Signpost Way

Valuation As A Coordination Device (Part 2)

This post was originally published by John Ryu on Medium

I wrote a post here awhile back titled “Valuation As A Coordination Device” but given the conversations today around valuations, I think it makes sense to highlight something I said in that post:

My response was to forget about that $5 million as valuation and to think of it more as a coordination device…

If everything goes the right way, what do you think the value of this startup will be 12 months from now?

And if you believe in the vision and potential growth trajectory, what does the ownership [and financing] of the company have to look like today so that everyone who has to be involved to enable it will be happy and motivated?

tldr: It’s helpful to think of a valuation as a coordination device that reflects the present state of a future high risk/high reward scenario playing out that makes everyone involved happy.


Valuation As A Coordination Device (Part 2)

You are the product until the product is ready


This post was originally published on Medium.

I meet with lots of founders who are quick to give me their startup elevator pitch. Yesterday, I was at an event where most of the founders I met were pre-product. They were all ready to get right into the pitch right as soon as we shook hands (this wasn’t a pitch event). I found myself saying “Great, I’d love to check it out when it launches” and the conversations continued on for a bit but they all pretty much ended there.

If you’re pre-product, I’d suggest a completely different way to approach these conversations — focus the story on yourself because you are the product until the product is ready.

Talk about who you are and what you know. Display your passion. Develop the story to show why you’re the right founder to be solving the problem you’re focusing on. Use this approach to build relationships so that when your product is ready for demo, investors will remember you and have context.

You are the product until the product is ready

Guest Post: Why You Should Constantly ‘Fire’ Yourself and Your Employees


Andrew Cohen is the Founder and CEO of Brainscape, an adaptive mobile education platform that helps you learn faster.  This article originally appeared at Entrepreneur.  You can follow Andrew on Twitter.

I spent the first several years of my career working for a federal government department in Washington, DC. One of my strongest impressions of that experience is how monotonous everyone’s job was. Rather than encouraging each employee to “automate” or delegate newly developed processes and thus make time for new and exciting work, they just stuck with the same old routine.

Government departments have little incentive to squeeze more work from fewer/cheaper employees. Cutting costs for this year would only cause their budget to be slashed for the next fiscal year. That’s why bureaucracies are incentived to grow in spending but not in productivity.

Building a company is the exact opposite. A startup’s primary purpose is to prove it can solve an existing problem more efficiently than existing solutions. When you don’t yet have unlimited funds to increase your full-time head count, then the only way to grow is to increase the productivity of your current team. You have to automate, eliminate or delegate new processes as fast as possible to free your valuable mental bandwidth for higher-level growth tasks.

In other words, everyone on the team should constantly “get fired” from individual tasks, while freeing their mind to work on higher-level managerial thinking that helps them grow into the next stage in their career.

This level of rigor should be taken by every team member who is currently responsible for any “monotonous” daily, weekly or monthly tasks. For example, your engineers may want to automate parts of your code deployment or software-testing processes, so they can better focus on creating and managing new product features.

You (or your CFO) may want to offload your payroll responsibilities to a third-party system such as ADP or ZenPayroll, so you can focus on raising money from investors. You may even want your junior-level employees to delegate some of their work to a virtual assistant. The important thing is that your whole team constantly “fires themselves” from any part of their role that can be offloaded to another resource that is “cheaper” than they are.

At Brainscape, we make extensive use of freelancer marketplaces such as oDesk to easily find, recruit and manage people to do things that are outside of the core skill sets of our existing full-time team. We use these virtual assistants for tasks such as customer service, software testing, copywriting, editing, bookkeeping, translating, voice recordings, market research, data entry and the occasional graphic design touch up. Eventually some of these roles might become full-time positions, but for now, oDesk provides us the perfect balance of talent and flexibility. It allows everyone on the Brainscape team to be a manager and not just a doer.

Whatever monotonous tasks you decide to automate and delegate at your company, you and your team will benefit from having more time to focus on higher-level growth activities. After all, the ability to consistently abstract and delegate roles is the mechanic by which small companies grow into large ones, and by which junior employees evolve into seasoned executives. A team that fires itself every day will grow faster and attract more capital than a team whose members become complacent with their existing jobs.



Guest Post: Why You Should Constantly ‘Fire’ Yourself and Your Employees