When we first started our company, convertible notes were all the rage, and they were pitched to me like this – “Convertible notes are cheaper and easier than priced rounds.” Then I talked to a friend who had raised $1M+ on a note and was paying a pretty penny in interest now that the note had reached maturity and he hadn’t raised his next round. He said, “I wish I never had raised using a note, an equity financing would have been a lot cheaper in the long run.”
That stuck with me, and it also inspired me to do a deeper dive into the differences between convertible notes and priced rounds. What I learned is that, at at early stage (i.e. raising your first $2M or less), the idea that notes are “cheaper” and “easier” doesn’t really pan out. When it comes to all of the complexity that people attribute to priced rounds, I actually found the opposite to be true, notes add more complexity, the complexity just comes into play later on down the road…which is usually the worst timing.
I think the reason why founders get tricked into thinking that Convertible Notes are cheaper is because the upfront costs might be lower, but if you do the math, the end-to-end process can actually be more expensive than raising a proper equity round.
You may have heard that it’s cheaper, faster and easier to do a convertible note, but the fact is that convertible notes are going to end up costing the company approximately 25% MORE than an equity deal. The reason for this is that when the note converts, then it converts into EQUITY. That means that the company pays twice for the legal: once to do the note and another time to do the equity. So if a convertible note cost $2500 in legal fees and the equity deal cost $10,000, then the convertible note all-in is going to cost the company $12,500. Why not just do it right in the first place and put all that money to work for the company?(Source – Rockies Venture Club)
Another thing I hear a lot about convertible notes is that it allows you to delay the dreaded conversation about valuation. Sorry, but this just isn’t true. Pretty much every note you’ll see has a cap, and yeah – most investors look at that cap and see it as your valuation. Yes, there’s some math here that makes it different but nobody’s doing that math. The reality is that you aren’t delaying the process of setting a price by using a capped convertible note, you’re just communicating the price in a different way.
So why not just have an uncapped note? Good luck getting any investors onboard with that. Uncapped notes are more of a myth than a reality IMO.
Now let’s talk about maturity dates. Unlike equity investments, which are an actual investment, i.e. someone pays you money for a chunk of your company, notes are debt. Like most debt, there are stipulations on what happens if you don’t pay off (or convert) the debt in a given timeframe.
Most founders pick somewhere in the 12 – 18 month range for a maturity date assuming by then they’ll raise a nice big round, convert the note, and ride their unicorn into the sunset. Now here’s the harsh reality. Just about everything you plan for will take twice as long and cost twice as much…which means that once your maturity date hits, there’s a good chance you’re not going to be where you thought you were.
I know what you’re thinking now. But wait!?! Everything I read on Techcrunch and all of my favorite VC bloggers show explosive growth followed by a nice juicy A Round within 12 – 18 months of raising my Seed round, so isn’t that the norm? What about all those fancy projections I made and pitched over and over again…are you saying those aren’t going to happen?!?
Sorry to be the bearer of bad news. The norm is for companies to go bust in that timeframe. For those who can power through and find some product-market-fit, they’re alive by the note maturity date but they might not be in a place to raise. Sounds grim? It can be, which is why setting a relatively arbitrary date on when you’ll be ready to raise next doesn’t really make much sense so early in the game. Oh and if you’re wrong, you’ll end up paying interest, which means along with now being off your plan and running low on money, you’re now bleeding even more money.
Okay, now for the last but certainly not least disadvantage to a convertible note – the strange misalignment of incentives that takes place with a note if the company is in a position to raise an A Round.
A second disadvantage is the nonalignment of incentives between seed-round investors and company management. The latter want the Series A round to be at as high a valuation as possible, so they dilute their ownership as little as they can. In contrast, seed investors want the next round to be as low as possible so they get the biggest percentage of the company that they can for their investment.(Source – Wharton Magazine)
So let’s summarize:
- In the end, convertible notes can end up costing more money than equity financing, and add a lot more complexity later down the road
- Note maturity dates add stress around a relatively arbitrary date
- Interest payments (post-maturity) can bleed money from a startup at their most vulnerable time
- Incentives between founders and investors going into the A Round can get dicey
- You’re not delaying the conversation about price, seriously you’re not so don’t trick yourself into thinking that a cap is completely different. Yes it’s different but investors will still say “oh their cap was $6M but I just don’t think they’re worth that much” all day long…
- With an equity round you’re giving investors a piece of your company, with a note you’re taking on debt, and well, debt is debt and I don’t think you should choose debt if you have the option not to (sounds simple right?)
I know this is a relatively controversial topic but heck, I’m not alone in my distaste for convertible notes, here’s some additional reading you can do if you don’t want to take my word for it because who the heck is this Morgan guy anyway?
Further reading on why convertible notes suck:
Wharton Magazine – The Two Disadvantages of Convertible Notes
Rockies Venture Club – Ten Reasons Why Not To Use Convertible Debt
Lighter Capital – Top 5 things to consider before getting convertible debt
Alex Iskold – The absolute worst thing about convertible debt