This post discusses the relative benefits of using convertible notes versus equity financing when raising money for early stage technology startups.
Convertible debt is a loan to a company that will (probably) turn into equity at a Series A financing. For example, a seed investor loans StartupCo $100,000 and agrees that this money will be used to buy $100,000 worth of StartupCo stock, but only after we figure out how much StartupCo stock is worth.
When do we find out how much the stock is worth? When the company negotiates the price of the stock with professional investors at the Series A round. This delay has two advantages. First, it allows the company time to ramp up, sell some product, and create some metrics (user growth, revenues, etc.). Second, the extra time and growth makes the company big enough to attract professional investors.
Convertible notes have two big advantages over early equity rounds. First, the startup founder and the seed investor do not need to put a valuation on the company at the time the convertible note is signed and funded. They do not need to immediately say the $100,000 will buy (for example) 10% of the company. It’s difficult, and perhaps arbitrary, to do this type of valuation when the company is just a prototype and a dream. Second, the legal mechanics of convertible notes are simpler than seed equity, and so convertible notes tend to result in a lower legal bill.
Discounts and Valuation Caps
Since early stage investment is risky, investors often sweeten their deal by asking for a “discount” and a “valuation cap.” A discount refers to a discount on the price the investor will be paying when she eventually buys StartupCo stock (i.e., “converts” to equity). A valuation cap is essentially an upper limit on the price she will pay per share.
A Example with Widgets Instead of Startups
Instead of a startup, imagine a ship with 1,000 widgets in its cargo hold. These widgets are a brand new product, so we don’t know exactly how much each widget should cost. Also, the shipping route is dangerous, so some or all of the widgets might get lost at sea.
Pop’s Widget Shop wants to buy $100 worth of widgets, but since we don’t know how much a widget is worth yet, we don’t know how many widgets that $100 will buy. Pop’s loans the shipper $100 now, which they spend on fuel. A month later, the ship safely reaches port. At port, Wal-Mart agrees to buy 100 widgets for $5,000. This is great, because we now know that a single widget is worth $50, and that the cargo of 1,000 widgets is worth $50,000 total. Pop’s $100 loan to the ship “converts” to 2 widgets.
But why should Pop’s, the early widget buyer, only get the same deal as Wal-Mart, who came later and took less risk? Pop’s paid for widgets before it got to inspect them, and it took a risk that the ship might crash without delivering any widgets at all. This is where the “discount” and “valuation cap” come in.
A 20% discount is like saying “Pop’s, as an early buyer of a high-risk product, is going to get its widgets at a 20% discount from the later buyers.” So while Wal-Mart, who bought later and took less risk, pays $50 per widget, Pop’s pays $40 per widget. This 20% discounts is for buying early and taking more risk.
A $10,000 valuation cap is like saying “we agree now, before really inspecting the widgets, that for the purposes of Widget Shop’s purchase, the most the total widget cargo will be worth is $10,000.” Or put differently, the most that Pop’s will have to pay per widget is $10 (because there are 1,000 total widgets on the boat, and we agreed that the maximum valuation of the total cargo is $10,000).
(a) If Wal-Mart pays $5 per widget, then Pop’s pays the same $5. The $5 price is below the valuation cap, so the cap has no effect. (b) If Wal-Mart pays $10 per widget, then Pop’s still pays the same $10. We are right at the valuation cap in this example. (c) But if Wal-Mart pays $20 per widget, then Pop’s is still only paying $10. Regardless of what Wal-Mart pays, the most Pop’s will ever have to pay is $10.
The higher the eventual price, the sweeter the benefit of the valuation cap to the early buyer.
Some Y Combinator Controversy
In 2010, Paul Graham of Y Combinator declared that “Convertible notes have won.”
Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.— Paul Graham (@paulg) August 28, 2010
At the time, many people disagreed, arguing that options or warrants are better for founders, and are not necessarily more expensive to draft and negotiate. By the end of 2013, Paul Graham and Y Combinator had come around, announcing the “Safe, a Replacement for Convertible Notes.”
Announcing the Safe, a Replacement for Convertible Notes: http://t.co/drN2Nnolwy— Paul Graham (@paulg) December 6, 2013
Convertible Debt Basics
How Convertible Debt Works. Brad Feld, 2011. Foundry Group partners Brad Feld and Jason Mendelson discuss the details of convertible debt deals, including the discount, valuation caps, and conversion mechanics.
Bridges or Seeds? A Primer on Your First Financing. Jose Ancer, 2012. Raising a round between $500k and $1M requires you to carefully balance the benefits of a convertible note versus an equity round. Lots of good guidance in this primer.
Thoughts on Convertible Notes. Manu Kumar (2011). Convertible debt is appropriate for bridge financing (when a priced equity round is imminent), but convertible debt may misalign incentives in seed financing. E.g., for an uncapped note, the founders will want maximize the company’s valuation at the next financing (minimizing founder dilution), but the investor will want to minimize the valuation so that the dollars committed on the note but as many shares as possible at conversion.
Valuation caps on convertible notes, explained with graphs. Martin Kleppmann, 2010.
Convertible Notes. Clerky, 2016.
Arguments Against Convertible Debt
The Truth About Convertible Debt at Startups and The Hidden Terms You Didn’t Understand. Mark Suster, 2012. “Convertible debt with NO cap is stupid for investors. Convertible debt WITH a cap is stupid for founders.” Convertible debt with a cap is a lot like a full-ratchet anti-dilution clause.
Bad Notes on Venture Capital. Mark Suster, 2014. A capped convertible note is basically a priced round. Mark gives 5 examples, in conversation format, of how convertible notes can cause problems when it’s time to raise the next round of financing.
Why Seed Investors Don’t Like Convertible Notes. Chris Dixon, 2009. (1) Uncapped convertible notes misalign incentives – for the next funding round, the entrepreneur benefits from a higher valuation, the investor from a low one. (2) VCs in subsequent rounds may refuse to give the seed investors their 20% discount (by making the VC investment contingent upon modifying the convertible debt contract).
Convertible and SAFE Notes . Fred Wilson, 2017. Fred is concerned that convertible notes make it difficult for founders and angel investors to computer their dilution and ownership. [note - this confusion can easily be solved by issuing a pro forma cap table, which we always provide at Egan Nelson.]
Convertible Debt vs. Priced Equity Rounds
Converts Versus equity Deals. Chris Dixon, 2010. “To the extent that I know anything about seed investing, I learned it from Ron Conway. I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal)… I was shocked. I asked him ‘what if X or Y happens and the entrepreneur screws you.’ Ron said something like ‘then I lose my money and never do business with that person again.’”
Is convertible debt preferable to equity? Mark Suster, 2010. If the entrepreneur has a choice between pricing a round and not pricing a round, for the exact same investors, then she shouldn’t price it. But remember that a convertible note with a cap is essentially a priced round.
Convertible Equity and SAFEs
“Convertible Equity” is an old idea that’s coming back into style. The idea is to achieve the simplicity of a convertible note but without the drawbacks of debt.
Safe, a Replacement for Convertible Notes. Paul Graham, 2014. “Safe” stands for “Simple Agreement for Future Equity.” An investor makes a cash investment in a company, but gets company stock at a later date, in connection with a specific event.
Safe Financing Documents. Y Combinator, 2014.
Startups Can’t Borrow Their Way to Success. Adeo Ressi, 2012. Startups that take Convertible Equity will not be burdened with debt on their books that they have to renegotiate every 12 to 18 months. They don’t have to worry about a disgruntled investor calling in a debt and threatening to bankrupt the business. They can also share their balance sheet with big partners without appearing insolvent.