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.