Investors Are Sick of Convertible Notes

Because I run in the early stage community, I speak with a lot of founders about early stage financing.  Most of them raise convertible debt notes.  Marc Suster, Brad Feld and Fred Wilson have written about how they work-I have nothing to add on that.  I suggest you read all their blog posts for their thoughts because they are really good and will help founders think about their financing strategy.

From my perspective as an early stage investor, I am sick of convertible debt.  I think other early stage investors are sick of them too.  Jason Heltzer and I were on a panel here in Chicago once and he made a good point.  Paraphrasing what he said, “Capped convertible debt creates a perverse incentive where the first investors are pulling for you to not do great out of the box so they can invest at a cheaper price.”  Uncapped convertible debt is a non-starter because investors assume all the risk.

Here are some of the reasons I hate convertible debt.

  • Usually the company doesn’t raise enough capital.  Then, once they get going they are out of money and constantly on the money chase instead of the building company chase.  Convertible debt rounds continue to spoon feed capital to companies.  That rarely works.
  • Priced rounds let me know exactly where I stand as an investor.  Priced rounds help me set metrics for the next round.  Convertible debt is squishy.
  • Priced rounds demand that a real board of directors be put in place to help founders build and run the company.  Not a board of advisors that has no impact.
  • Priced rounds force the founder/investor to have a real negotiation.  It forces the founder to lay their cards on the table and say what they are worth.  It also forces investors to lay their cards on the table and say what they are willing to pay to be a part of the journey.  Convertible debt moves that negotiation to the next round-where they will have it anyway.  Investors and founders can learn a lot about each other from this negotiation.
  • Priced rounds put the financing strategy in place.  Corporate finance for startups is just like a marketing strategy.  Price too high and screw up, you are faced with a down round.  Price too low, not enough equity for founders to have economic incentive to build a blow out company.
  • Priced rounds are less risky than convertible debt for both sides.  Convertible debt rounds constantly stay open and anyone with a checkbook comes in the deal.  Not so with priced rounds.
  • Priced rounds force startups to convert to structures VCs are comfortable with.  By converting from an LLC to a C-Corp, the company is prepared for succeeding venture rounds and eventual exit.  LLC companies have squishier legal standards.
  • Priced rounds allocate equity with certainty.  Convertible debt rounds with caps are still subject to negotiation, unless all the terms of the note are explicit with corresponding waterfalls-and even then it can be interpreted by lawyers.

In a market where valuations are supposedly getting frothy, having priced rounds keeps that froth in check.  If VCs or investors want to bid up your deal, they are creating their own froth and will have no one to blame but themselves if things go south.

As an investor, I almost never see priced rounds anymore.  The reverse should be true.  Convertible debt notes are great tools for bridge financing rounds as the startup transitions from one phase to another between priced rounds.

If you are a founder, look your investor in the eye and tell them what you think you are worth.  Raise a priced round.