I spent this past week catching up on work after being focused on running the Entrepreneur’s BootCamp at Babson College all of last week. I am currently helping several companies raise capital at often find myself trying to convince entrepreneurs to avoid convertible notes and especially stacking convertible notes.
As anyone who has taken my Entrepreneurial Finance class knows, I really don’t like convertible and SAFE notes for a host of reasons. It was propitious when Fred Wilson of USV wrote, once again, about his dislike for these notes last week. Fred has written several excellent posts in the past expressing his disdain for notes, but I fear that, like warning labels on cigarettes, his advice goes unheeded. This is what Fred has to say last week:
“They defer the issue of valuation and, more importantly, dilution, until a later date. I think dilution is way too important of an issue to defer, for even a second.
They obfuscate the amount of dilution the founder(s) is taking. I believe a founding team should know exactly how much of the company they own at every second of the journey. Notes hide this from them, particularly the less sophisticated founders.
They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens. This is the worst thing about notes and doing more than one is almost always a problem in the making.
They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert. I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did. And they blame the founder(s) or us for it and it is honestly not anyone’s fault other than the harebrained structure (notes) they used to finance their company.”
I couldn’t agree more with Fred. Whenever I take entrepreneurs through the math and full explanation, they sometimes forge ahead with the notion that they are immune to the issues that are caused by convertible notes. The rationale that is often expressed is that notes are fast and cheap. So is meat on a stick from a push cart on Broadway and 44th street, but that don’t make it good.
One alternative to convertible notes is to simply do a priced Series A. There are enough VCs around who will move pretty quickly and inexpensively to a close for good deals. There is value in going through the due diligence process in terms of the feedback and advice that might help prevent a pivot somewhere in the future.
If you do a convertible note, then do just one and try to convince the investors to convert to common stock to avoid the cap table issues that Fred describes.
If you’d like to learn more about the perils of convertible notes check out my online course, Founder Finance, where I cover all aspects of raising capital in great detail.