Pesky little creatures called Notes

Note on the Notes being used these days.

It’s so common these days to run into Seed stage companies raising capital on a Convertible Note instead of through Equity. We have done our fair share of such financings at GREE Ventures. It’s not because we want to do things through a note. It’s usually because the founder already has raised capital within the last month or two on such a note, and instead of negotiating an equity deal it’s just easier to tag along on the same terms as the note, even though we likely end up taking more than half the financing amount.

We are a small and lean team (made even smaller recently). As a result, we are usually not the first ones to be investing in a deal, especially when compared to angel investors. What this means is that if a founder is raising on a Convertible Note, by the time we see the deal, they have probably already gone out and raised a few thousand dollars on the note with a pre-discussed cap and discount. If we think the pricing and discount is fair, we end up just running with the same notes. But it is not our preferred way of doing things. It really hit me when I was churning out a cap table for a recent financing and now I can truly appreciate what Jason Lemkin from Saastr says here. I just don’t know how much we got as an investor, and the cap table is still in the air, and I don’t like adding in more uncertainty to an already uncertain venture risk investment.

I have asked founders in this region why they like to do things through a note rather than an equity deal and the answer I usually get is synonymous to what the founders would end up reading through a preliminary google search: it’s faster, cheaper, and overall better for the founders.

No it’s not.

Oh well I reword, mostly likely it’s not.

See this uncertainty? It’s because you never really know what you get with a note as both the parties just kicked the can down the road. So let’s break it down a little on how a founder usually sees and instead should see notes.

Assumed Advantages

Faster

This is the most common argument in favor of the notes. Founders often claim this is because the price doesn’t need to be negotiated. They also feel that somehow they can get a better price using a capped note. If you are one of them, I don’t think you clearly understand what you are doing here. Your cap already decides the price that the investor is willing to pay for the company now, and what’s worse, you don’t have a floor on it.

Let’s assume you raise $500k on a $5M cap, 20% discount note. You have given a ticket to the investor to convert at $5M price or even lower. Let’s say things don’t go as planned and you end up raising the next round at only $4M. Your note investor will then convert at a 20% discount to $4M, i.e. $3.2M. Not only have you set the $5M price in the best case scenario but also allowed the investor to get a better price in the worst case scenario.

And no, Seed stage equity documents do not take longer than a convertible note documents. In many cases we have formed and signed documents with our companies within two weeks, can’t get faster than that.

Cheaper

Usually people refer to the legal fees when talking about saving costs through a note. Again, this is not true. Sure, you might be able to get away with lower legal fee initially. But the moment you start layering notes with different prices, the cap table gets really messy. You’ll have to pay to clean up the mess at some point regardless, most likely in your next equity financing. If you are unlucky, the next round investor might even ask you to clean up the cap table first, which means you’ll have to fork extra cash from your own pocket at a time when you are likely running out of money and want to raise a new round. Not good at all.

Better Terms

This is the most common assumption. Notes = better terms. Sure, you are in effect saying that the current round investor gets the same terms as the next round investor. But you can always negotiate the same (and probably don’t even need to negotiate with a good investor) when doing the round through equity. Further, one of the biggest things that I explained above in terms of pricing is usually not noticed by the entrepreneurs. What I explained above is essentially what we call a “Full ratchet” anti dilution clause in an equity round and your convertible note automatically hands this over to the investor. It would be best to ready Mark Suster’s great post here to understand how what you are signing is essentially a full-ratchet.

Clearly, this doesn’t look all that good for the entrepreneurs. Why is every one going about doing their financing through this structure then? There are two main reasons as far as I can see.

1. Control: When raising on a note, post the financing you keep the “control” as a founder. Now I am not a big fan of the term “control” either. I feel it’s difficult for VCs to force entrepreneurs to do things one way or the other, so the “control” that the VC has is more of perception. That said, you do end up having control rights on financing, selling, and basically doing anything you want with the company. You don’t have to give away board seats nor negotiate rights such as tag-along, ROFRs etc. Is there really an advantage here, I am not so sure. Boards are good for your company, they help keeps your company aligned to its strategy and brings some sort of order to the chaos.
2. Rolling Close: This is for me the biggest advantage of Convertible notes. Notes are especially well suited for rolling closes as you do not have to wait for a lead investor to come and set the terms before you can accept money from the smaller investors. If you are raising money from Angel investors, you would prefer not to have a negotiation every time you find some one interested in putting $10000 into your company. Also, an indirect effect of this rolling close is inducing FOMO in VCs, and I am guilty of being afflicted with this as well. When I see a company I like raising on a note, I know I’ll have to move fast otherwise the company might end up raising from enough angels so that I won’t be able to get the allocation I need within the round. This pressure on an investor is good for the entrepreneur.

Apart from the two advantages discussed, I don’t see much reasons for using a Convertible note. And it’s not just me, almost all good VCs feel the same, including Fred Wilson here. But in case it is really important for you, it’s best to use a YCombinator SAFE or a 500 Startups’ KISS so you don’t run into unforeseen issues. These documents have already been used by a fair share of companies and there should not be anything dirty hiding in there such as multiple liquidation preferences.

Don’t agree with what I said? Raised money on Convertible notes and loved it? Ran into issues with notes in your next financing? Comment below and inform the community!