Why you should price your venture round

In today’s hot startup financing climate, convertible notes are all the rage. Everyone’s trying to raise money through a convertible note and postponing when their company gets valued.

This give and take between funders and founders is longstanding. At the moment, founders are calling the shots. That’s fine. Hopefully, with the exception of YC’s wildly overvalued grads, they’re not abusing those powers. Because things always go in cycles and if one side is overly greedy when they’re in charge the other side gets to reciprocate in the future. It’s just how the World works.

I’m working on the valuation of our fund’s portfolio at the moment. By default we like to price rounds and buy shares. But its a sign of the times that a decent portion of our investments are in convertible notes. As I look over this portfolio I see three big reasons why these founders might have been better off selling shares. Bare these in mind as you plot your own fundraising strategy:

Lock in a valuation today while times are good: Just because you raise money on a note with a $4M cap does not *guarantee* that your money will convert at that cap. If you fail to hit your milestones or if the funding climate gets colder that money and your next round  might convert at any valuation below $4M. You just never know.

Lock in terms today while times are good: The terms you set for your early shares set a precedent for all future rounds. While the climate is founder-friendly, you want to use that opportunity to set clean, founder-friendly terms for your shares and  keep these terms for future rounds.

Notes can be expensive: Finally, while founders tout the cheap legal costs as a reason to do notes, they are more expensive than founders realize. Not only do the notes convert at a discount to the cap (usually 20% discount), but interest accrues and converts at that same discount. If I hold a note with 10% interest for a year, then convert it, I am actually getting a 30% discount to the next round.

  • John Hammer

    One does not see enough discussion on convertible notes. As a former investment officer in a community development corporation, I did a couple dozen notes. It is an ideal instrument for organizations that are not in the business of valuation or maximizing return. It might be appropriate for some strategic investors as well.

    IMHO, it is not at all appropriate for V.C.s or individual investors and it may harm the company as well. For one, it leaves money on the table. If the investor receives a 20% discount to a priced round and the money raised by the note increases the theoretical valuation by a factor of two, risk is not compensated for.

    I have seen notes piled on top of notes. This can harm the capital structure and it is complicated to calculate a pre-money valuation for a priced round. I received a company term sheet last year that placed a pre-money valuation on the company that did not include the note conversion. It sounded pretty good until one looked at the details. In this same deal, the management shares/options got heavily diluted as the notes gave them an inflated sense of ownership.

    As a private investor, we do not do convertible notes.

  • I have not found convertible notes to be far and away cheaper than priced rounds. The biggest push we hear for notes is that they are “cheap” to get done on the legal side of things. If they aren’t negotiated sure they are cheap, but so are equity rounds. I agree completely about “locking in” your price, times ARE good.

    • Hey Adam, I agree. Since when was it a good idea to take the “easy” way. Being cheap or easy is not an argument that works with me. You should always do what’s best for the long term.

  • VC admits that convertible notes are favorable to founders, then proceeds to tell founders why they shouldn’t want them. It appears to be disingenuous to me.

    Convertibles are a crucial tool for founders and early on in a company’s life should likely be employed 100% of the time if it is possible.

    Whatever minor downside that is presented here is so miniscule compared to the benefits. The #1 benefit is the rolling close and variable terms. This allows the founder to raise a round over months and not have to herd the cats on a valuation, and employ the cash as it is received. This generates a lot more progress before raising the priced round. This is HUGE.

    • I did not say notes should never be used. The post is just pointing out some downsides to notes that most people don’t consider. They have their place in the financing mix for sure.

      But I don’t agree with seed stage companies raising > 1 year of cash by a note. Most seed stage investments fail. If you limit your upside going from seed to series A (which a note does), that forces the investor to do less seed deals and more later (de-risked) deals. That will have long term negative repercussions on the ecosystem.

      • The converse of your statement should probably be said more strongly: when you are raising your first bits of money, it is often the case that you are raising less than 1 year of runway.

        I think the “rolling raise” aka continuous raise is something that I’m going to investigate more deeply WITH priced rounds. Mark, any thoughts/experience on how that might be accomplished?

        • In my limited experience with this the rolling clause sounds better than it actually is. It creates some tension between investors. If I pay 5% more because I’m a week or a month later than someone else that can be a problem.
          If you want to try it with a priced round, best off doing a 2 step process: raise a note with a cap but where the trigger to convert is getting to $x on this round, not the next one. Use progressive discounts to incent early investors.

        • Yeah, that’s my default for dealing with notes. IMHO you shouldn’t use a note if you don’t already have a good idea when / where your next raise is coming from. We see the note and then no more raises in Canada too often.

          So, yes to priced rounds 🙂

        • To be clear what I’m saying is use the note in this raise. Say you’re raising $500k do it by notes that convert under pre-defined terms once you hit 500.

  • Corporations considering a financing by way of issuing convertibles also need to keep in mind that they may also be limiting their upside.