I totally get why i would be seen as biased. I have given this advice hundreds of times in small sessions verbally and I REALLY have no interest in driving my point of view for me. I do 2 deals a year. It barely matters to me personally.
Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s. I promise you you'll hear similar views to mine. Also, ask some very smart lawyers for a balanced view. I think you'll mostly hear the same.
re: gate keeper protecting the establishment. I know you don't know me but truthfully it is nothing of the sort. I think in simple life lessons. When you matter more to a small set of people they have more interest in helping you in tough times. If you never make mistakes or struggle then the argument of not having strong leads makes sense. It's just that this is the edge case.
Thank you for your reply on HN. Can you also please reply to grellas's post (at or near the top)? grellas is a "very smart lawyer" who posted some excellent counter-points to your original article. Personally, I'd love to hear your response.
I think grella said the advantages of convertible notes are:
1. First note is capped but later notes can be uncapped;
2. Fewer tax risks;
3. Doesn't mess up your equity pricing;
4. You can do a number of notes with different amounts raised;
5. You don't give your investors the kind of protections they would get in equity rounds.
I'd like to hear Mark's reply too. My opinion below.
I tend to think that all of these things (aside from the tax risks) are either inconsequential in comparison to equity financing (3, 4), or simply the result of having unsophisticated or uncaring investors (1, 5). The tax risks he did not explain; I assume he means the risk that the IRS would use an equity round to peg a value on shares or options given to employees that differs from what the company assumed. If so, this risk exists no matter what.
I agree that giving the investors less protective provisions or uncapped notes is better for the company. If you can get investors to agree to that, good for you, but that's separate from structure.
The primary problem with convertible notes as they are used today for entrepreneurs is that the investor gets the lower of the cap or a discount to the next round. This optionality is paid for by the entrepreneur. And while, as grella points out, the cost of this optionality is usually pretty low, so is the value of the benefits he points out.
I don't understand your "going back to the mid-90s" point.
I cofounded a company that was VC-funded in the late 90s, after having principal roles in two successful bootstrapped companies in the mid-90s.
What I don't understand about the point you're trying to make:
* Modern convertible debt financing of the form we're discussing --- unpriced rounds, rolling closes --- were not available in the 1990s.
* Entrepreneurs who fit the cohort you're implicitly defining --- people who raised VC in the 90s --- are effectively immune to the effect Patrick is describing. Executing a first VC-funded company well gets you your next VC-funded company. Nobody disputes that the priced-round VC system worked well for proven operators. The subtextual argument for convertible debt is that without it, you might not get the next Airbnb or Dropbox --- companies that barely even made it into YC.
Everyone else has covered the more substantive issues, but on your point about lawyers - as far as I can tell, there is nothing close to a consensus amongst top startup attorneys that convertible notes are a bad idea.
Part of this is that good startup attorneys can help their clients avoid most of the issues you discuss - i.e. explaining what the terms mean, explaining that discount-only notes are relatively uncommon, explaining what happens when you raise an equity round at a valuation less than the valuation cap, adding in provisions to prevent liquidity preference double-dipping, etc.
I think you are right - having a lead is very valuable - but you're also missing the other side of the argument.
Convertible notes have upsides, primarily that they give the entrepreneur significantly more leverage in a seed round. The benefits for entrepreneurs have been pretty clear in the last decade: lower dilution and much better terms.
So it strikes me that while there are certainly downsides to notes, I don't see the major upside addressed in your piece. This is what makes it seem a little self-serving, IMO, esp since the upsides you do address come across a little bit like strawmen.
I think the point of the article is that they don't give the entrepreneur more leverage. I don't think that there is a correlation between convertible note seed financings and rising valuations: valuations are rising for all types of financings over the last five years.
The downside to a note is exactly this: the cap in the note is the valuation an investor would pay. That is how I view it, as an investor. And when the next round is lower than the cap, it usually means the company is busted somehow. I am completely indifferent, as an investor, to a convertible note or equity because the outcome is generally the same for me. The reason I hate notes generally has to do with the negotiations around them (what's the term, what happens if the company gets acquired before the A, what happens if the other angels get pissy and try to claim that the company is in default, do I have pro-rata rights in the next round, etc.)
But my biggest fear with convertible notes is what the Series A VCs are going to do to me, the angel investor. They could generally not give a damn about me and since the company already has my money, I have no negotiating leverage if they decide to do anything aggressive. With an equity deal, I know what I have and, since it's very similar to what the founders have (common stock) it's hard to screw me without screwing the founders.
I'd like to know what you consider the upside of convertible notes, or how they give the entrepreneur leverage, because I just don't see them.
At a seed stage, the major cause of rising valuations is the massive competition for good deals. This is caused by the massive proliferation of angel investors. This is caused by simpler financings, including convertible notes.
Where does the entrepreneur get leverage? So many ways:
- small angel investors cant afford to spend a large amount on lawyers, so simple legal terms are enablers
- rolling closes are massive enablers. They mean you don't need a lead. Which means there isn't anyone with leverage. Which means if anyone thinks the price is too high they can drop out without affecting the price from the other investors. In fact, since you'll have cash in the bank from half your investors, you can raise with the financial pressure off, and demand a higher price from other investors.
- cheap legal fees allow smaller rounds (even a cheap priced round is 15-25k; our bill came to 42k). You can raise 100k in a weekend with no extra costs.
The massive proliferation of angels is not due to simpler documents. The massive proliferation of angels is due to the smaller amounts raised in seed rounds.
It's just as easy to use template equity financing docs as template debt financing docs. I'm not sure where this alleged complexity comes from. There is no intrinsic complexity of equity docs that doesn't exist for debt docs. I've negotiated debt docs (for real loans to companies further along that were far, far more complicated than any equity docs you've ever seen. Because having more than one type of financing in a company adds intrinsic complexity (because the interests of different parties are no longer identical.) The reason convertible debt docs are simple is because no one cares enough to legally protect themselves. If you and the investor cared that little in putting together equity docs, the equity docs would be just as simple.
You can do a rolling close with equity. At least half the equity financings I've been involved with in the last ten years have had more than one close (my firm in the 90s tried to be the only one in the round, so there was only one close.) You can also do an equity round with no lead just as easily as a debt round. Why not? The reason most equity rounds have leads is because smart investors insist on leads and smart investors prefer equity. That's correlation, not causation.
I've done priced seed rounds for less than $10k. Series A and later are more expensive because there are more reps and warranties and checking of charters and etc.
If you were to raise Priced Seed Round, you will get a lower valuation than the cap. The Notes need to be structured right, I agree with Mark on this.
If you do not have a cap, you are screwing your investors = this is very bad. You should treat your investors well and with respect. They will help you to grow the company.
If you have a cap that is too high, it will look bad in later rounds. Set the cap with current market.
If you have any control, liquidation terms in your Note = this is insane. The whole point is not to negotiate these terms when your company is just getting started. The Note should convert into the future Preferred Stock with all the rights that will be negotiated later by the VCs on angel investors' behalf. This is only fair for angel investors.
The Convertible Notes can cause all sorts of problems, sure. But the biggest point is that taking money is never free. I don't think Convertible Notes will cause more problems that Priced Seed Rounds. I actually think they cause less problems. Witness YC financing = version of Convertible Notes.
I take as a given that people will make comments that are self serving unless I have info to the contrary. Not that you have to of course (good enough to just relay the information which is definitely helpful in many contexts obviously) but shows how possibly including a preface with what you said here could further strengthen what you are taking your valuable time to blog about. (Hey it's not like your posts are short, right? What's a few more words at the top?)
When selling someone (or negotiating) I always find it helpful when people make a critique such as the parent comment. Someone a while back made a critique according to how I price a particular consulting service [1]. As a result of that one comment I changed the way I priced so as not to give the appearance that I am not working in someone's best interest. (Because I was in my mind all along but once someone questioned it I made the change and it's worked better. Reason being it's a small part of how I make money and as you said "it barely matters to me personally". But the change was easy enough so why not?).
[1] "Why then is it in your best interest to get me the lowest price (I help buy things that are very expensive) if your compensation is at least partly dependent on the amount I pay for it?"
> Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s.
Entrepreneurs fitting these criteria are highly likely to be investors. Entrepreneurs today are part-time angels after fewer companies. If such an entrepreneur is giving advice they are likely to possess any bias investors are assumed to possess, that is, if their channel to the less experienced entrepreneur isn't already predicated on the potential for investment.
This would not be a good test for proving or disproving bias.
In addition to everything suggested here, I'm also very interested in understanding the following question:
how on earth are an investor and an early-stage entrepreneur supposed to come to a valuation number when the history of the company is pretty much non-existant and the projections of financials are a shot in the dark at best.
Sales and Faith. With a pre-revenue, pre-launch company, from the entrepreneur's side, it is pure sales. And from the investor's side, it is pure faith.
Build a good story, believe in it, and sell it. I can build a financial model with the best of them. But as Brad Feld once said about all early stage companies, "Your revenue forecast is wrong." You have to believe enough in yourself and your company to convince someone else to believe in you and back that up with cash.
It's a bet and always will be. And like any bet, some are more sure than others. But lots of "sure things" fail, and more than a few long-shots win and pay out big. Sales and Faith.
Mark - It's natural for us to assume people are "talking their book" when they give advice. (How many CEOs talk about "Working for passion" as an excuse to underpay?)
Thank you anyway for joining us here to share your contrarian view. If everyone agreed with each other, this would be a very boring place.
"massive boondoggle" because you were there and know what my business there was? I was there meeting tech professionals, VCs, government officials and investors in VC funds.
I went to China to meet with tech firms, VCs and government officials. And to learn about the funding environment for Chinese firms investing in VCs. I know that Dave also met with LPs (who invest in in VC funds). But thanks for making the blind assumption about my trip and motives. Appreciate it.
I read your response, David. Frankly, I think you do many entrepreneurs an injustice in assuming that I'm talking about VC funded entrepreneurs only. At my talk at University of Chicago I repeated advice I give every time I speak "90+% of you should never raise VC. It's not right for you. Better that you raise smaller amounts of money and keep control of your business."
And many small startups have a much worse cash situation than those fueled by VC but your post fails to consider that. Many of them have loans, sibling / parent money and the like. It's actually much harder on them.
Or how about physical or retail businesses? I know many non-tech entrepreneurs who have gone through personal bankruptcy due to this. Including my own parents. Which led them to get divorced.
Fair point Mark, I do not know you. Even though my post may come across as aggressive, that wasn't my intent. I'm just getting started with blogging, and next time I'll have to be more careful with my language. Apologies.
I agree that VC funding is not the only path to stressful business, although it certainly helps a lot. In this sense, VC is a part of a larger problem - people's tendency to take on more risk than they should. I dare say that if more people lived and did business within their means, we'd all be calmer, have less bankruptcies, and maybe even less divorces.
It is very easy to read your post and come away with the feeling that being an entrepreneur is necessarily stressful, and that just isn't the case. It starts being stressful when you can't meet your obligations, and that mostly happens when your ability to meet your obligations is heavily dependent on circumstances you can't control - circumstances like relying on outside money.
Is VC better than loans from family? Most definitely, because by taking money from someone who fully appreciates their potential losses, everyone gets to be less emotional about the whole thing.
Still, I believe that by not taking any outside money, or extracting a heavy price from yourself, you get a shot at a significantly calmer variant of Entrepreneurship, and that's something people should know.
Mark, the method David says, purely bootstrapped, keep your day job until its profitable, no outside investors even family.... is the safer road and avoids many of the pitfalls you outline. Of course, you still have to worry about the market changing, losing a client, your cost structure vs your competitors, and the like. All the things that your current boss worries about, you get to inherit.
But also the VC, angel, or other investor method gives you cash up front to put off some worries on day 1, but as Mark says, when you hire someone, you have to look them in the face knowing you only have 6 months cash in the bank.
With the bootstrap method, you only have 1 week cash in the bank.
Both can be stressful. I guess having other people depending on you besides yourself is less stressful in some ways, but also less (0) chance of a home run exit.
@msuster I can understand how you found the title of the post disrespectful to you but I think he might have been going for the "Bitch Please" meme [1] rather than any actual intention to be disrespectful.
You're a well known and well respected entrepreneur turned VC (as opposed to VCs that have never seen the pain of being an entrepreneur themselves) so I doubt that anyone is going to take the "bitch please" part too seriously.
Ofcourse not being at the receiving end of that post maybe my perspective is different and I'd react similarly.
How could he not think you're talking about VC funded entrepreneurs only. Some selections:
"we have closed $150 million in our 4th fund...now you know why I’ve had many nights away, many airports and much time on the road."
"Raise money. Need money. More money. Yes, please give me money. "
"I mean you never know if your investors are REALLY going to keep backing you. "
"If I told my VCs would they then lose interest in our next round? "
Your slides are from Seedcon which is all about VC.
Almost nothing about making money from paying customers. Almost no worry about if customers are really going to keep backing you, or keep interested. Almost entirely about keeping VCs happy.
I will have to agree with you (Mark) on this one. I was at the the U of C talk and you repeated that line multiple times. I don't know what the OP would assume you were only talking about VC's only. Apparently he doesn't like people giving honest advice!
Not true. The full ratchet is implicit in the deal. If the deal said $8m cap and next investor invests at $4m then the deal gets done as $4m and doesn't impact the next investor. It comes out of founders' equity. It is the "equivalent" of a full ratchet but disappears after the deal is done.
I didn't miss that point. I agree with what you say. But - there are very few companies that could pull this off so my post was to point this out to people.
It may be obvious to you but all the chatter this week has been about getting big rounds of VC before M&A. My thesis was that this will backfire for 99% of companies. In Instagram's case it worked like a charm. Precisely because they were so valuable to Facebook.
So, yes, I think Instagram "pulled an Instragram" if I could be so recursive.
My term sheet wasn't signed so I would have understood if the entrepreneur chose the other partner.
In the case of the new vc / old vc example that wasn't me ... yes, there was a 'no shop' clause. but ...
1. those are mostly unenforceable (is a vc going to sue an entrepreneur over no shop? not likely)
2. if the team really wants to get around it they can just run out the clock. most no shops are 45-60 days.
In the end, a term sheet is really just an expression of honor and reputation.
Thank you. I wish more people saw it that way. I always believe in negotiating / seeking competitive deals. But once you agree a deal with people you honor it.
To be more clear (and I came back to edit for more clarity and saw your reply that paralleled my ambiguous construction) it's about the VC (you) not backstabbing your coinvestor.
IF (and it isn't clear from my reading) the company didn't have signed papers with your first coinvestor, they are well within rights to drop the investor. But you have a responsibility to not abuse the trust the coinvestor gave you.
If the company, gets a better whole offer, good on them. But they can't chisel apart the first offer.
1. You negotiate and have a handshake deal with a company for a round of funding.
2. The company gets an offer for a higher valuation from someone who wants in on the round.
3. The CEO asks you whether to take them or not, but basically leaves it up to you?
In other words, assuming the CEO didn't "backstab" you but rather sought your advice, would you be upset that he's even considering a different deal? Would you tell him he should take it, assuming the deal is still worthwhile for you? How would you react?
that is EXACTLY what happened in the situation I described. We hadn't yet signed the term sheet. So I told the CEO that I would understand if he went with the other firm. But that I personally couldn't be involved with the deal for reasons I described. Until a CEO has signed the term sheet (or gives you an email saying they will) I assume they are still negotiating with others.
I'm mostly interested in whether you would hold it against the CEO for asking your opinion on the matter. It sounds like you might be implying that the CEO shouldn't even be considering the decision, whereas I would assume a CEO working with you would want to feel like he can be open with you about his/her dilemmas.
I totally get why i would be seen as biased. I have given this advice hundreds of times in small sessions verbally and I REALLY have no interest in driving my point of view for me. I do 2 deals a year. It barely matters to me personally.
Do me a favor. Ask around to experienced entrepreneurs who have done 3-5 companies and stretching back to at least the mid to late 90s. I promise you you'll hear similar views to mine. Also, ask some very smart lawyers for a balanced view. I think you'll mostly hear the same.
re: gate keeper protecting the establishment. I know you don't know me but truthfully it is nothing of the sort. I think in simple life lessons. When you matter more to a small set of people they have more interest in helping you in tough times. If you never make mistakes or struggle then the argument of not having strong leads makes sense. It's just that this is the edge case.
Good luck.