A popular option in seed round financing is a convertible note instead of setting a valuation in an equity financing. A convertible note is basically a loan where the investors convert the debt into equity in the next round of financing at a step up. A common step up is 20%, which means for every dollar the investors lend, they get $1.20 worth of shares in the subsequent round.
The appeal of convertible notes is 1) it defers the negotiation about valuation to the next round 2) it is often much cheaper in terms of legal fees (~$5k versus $20-40K).
Here’s why a lot of seed investors don’t like convertible notes:
1) Most importantly, they split the entrepreneur’s and investors’ incentives – for the subsequent round, the entrepreneur benefits from a higher valuation, the investor from a low one. Most investors work hard despite this to help the company, but nevertheless the note creates friction between people who should be working in tandem.
2) On more than a few occasions VCs in subsequent rounds have said “I don’t want to give the seed investors a 20% step up.” Sure, the step up is in a contract, but the investor in the subsequent round can always make their investment contingent upon modifying that contract. In the end, it ends up pitting seed investors who wants their step up versus entrepreneur who wants to get the financing done, and the seed investor is forced to choose between getting the step up they deserve and being “the bad guy” who spoils the financing.
One increasingly popular compromise is to do a “convertible with a cap.” What this mean is that you set a cap of $N million dollars valuation and a step up of M%, and on the subsequent round the seed investor gets the better of the two. If the cap is low enough, this mostly rectifies #1 above since the investor has the economic incentive to increase the valuation above the cap. It doesn’t rectify #2, however, but does have the benefit of being significantly cheaper in terms of legal fees than a proper equity financing. There is nothing worse than spending 5%-10% of your seed round on lawyers.
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good comments on hacker news: http://news.ycombinator.com/item?id=761767
What are your thoughts on this?
[...] Dixon: Why Seed Investors Don’t Like Convertible Notes. Interesting comment on hacker news from SV startup [...]
i wonder what’s pros & cons of offering founder’s stock to early seed investors?
Re hacker news -
http://news.ycombinator.com/item?id=761767
I simply disagree with the commenter. Just think through the incentives. If, as an investor, my convertible note converts at the next valuation price, do I want to pay a high price or a low price? As an entrepreneur, do you want investors who are incented to see you get a low valuation?
thanks, Chris!
[...] cdixon.org / Why seed investors don’t like convertible notes (tags: startup vc) [...]
Another reason that seed investors dont like convertibles is because they are simply a more complicated and esoteric financing instrument. It’s hard enough to sell your earliest investors – they are investing at by far the riskiest period in corporate history, most often with their hard earned savings. Talk about a slap in the face to then ask them to invest their money without any sense of real ownership and the knowledge that an unknown set of VCs will later dictate the terms on their investment. VCs take infinitely less risk with LPs money from the comfort of their ivory towers, but then get to call the shots?
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My company (which runs a nascent concept in the dating space called howaboutwe.com) is closing a seed round with a convertible note in which we put in an arbitrary dilution floor–which is essentially the same as putting in a valuation cap. The seed investors can’t be dilluted to less than X% in subsequent valuation-determining events. I think it was a good solution to this problem. The big plus of a conv note is that it allows a financing without a valuation…that plus outweighs–in cases where a valuation would be hard to make–a lot of the downsides ppl mention above.
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