Ask HN: Was I just offered horrible convertible note terms?

[throwawayuc]

Was just offered $120K investment w/ a $500K cap; and 25% discount.

Some background: This is my first time taking money for my startup, so I ran it by my "silicon valley advisor" (a buddy from college who runs a notable tech startup in SV). I asked him what he thought of the terms, and he said that they are the most entrepreneur-unfriendly terms he has ever seen. His main concern was how low the cap was set at. He said I should insist on a $4M cap, and not accept anything under $2M.

My dilemma though, is we're currently pre-revenue; and I need this cash injection to propel my startup through our launch.

Isn't the cap on a convertible note akin to a pre-money company valuation? If so, I honestly agree with the investor that we are only worth ~$500K. I mean, we're pre-revenue, so $500K is optimistic IMHO.

Personally, I have a proven track record of building and exiting companies. Nothing huge; my last business was acquired for $250,000 last year.

I'm confident that I can make this business successful; but I don't want to screw myself over by taking this cash now, when in a year or so I may be seeking Series-A financing from a large VC; and don't want to turn them off by having accepted such poor seed investment terms.

Couple questions:

1) Do you feel like $120K with $500K cap, and 25% discount is really that bad of a deal?

2) If I take this deal as-is, do you anticipate backlash from future investors?

3) Where do I have negotiating leverage? Should I tell him I want a $2M cap but am willing to increase the discount to 30%? Should I offer to pay interest on the note?

4) I realize posting to HN is no substitute for bonafide legal counsel; so is there someone you would refer me to?

Thanks everyone.

[danieljeff]

I'm no expert but that sounds pretty bad.

You say you "need" the cash. What do you need it for? At the very early stages you may need cash much less then you think you do. Cash feels like it will remove headaches but you are adding an investor to the mix at terrible terms which could add headaches. Could be a wash.

[throwawayuc]

I've got a team of 8 full time people (half are salaried and half are only commission). We're hemorrhaging cash as we roll out our marketing plan. Plus we have features on our site like "Refer a friend, earn $10 when their first order ships." That money has to come from somewhere.

My only other option is to get as many personally-guaranteed credit cards as I can and just use them instead of taking on an investor. But this seems more high-risk.

[argonaut]

-This is a bad deal. The discount is sort of bad; it's somewhat unfriendly as it's on the high side, but it's not unheard of. The cap is pretty bad, though, and you combine both of those and you have fairly unfriendly terms.

-Convertible debt notes already come with a (low) interest rate.

-It's pretty clear the reason you are getting such bad terms is because you have no leverage in the negotiation. You've made it clear that your company desperately needs the money; the investor probably knows you're desperate and that's why you get such bad terms. There is a lot of truth to the saying that it's best to raise money when you don't need it: because then you can afford to walk away from the deal or spend more time finding other offers. Firstly, try to negotiate better terms. When someone presents a term sheet to you, it's meant to be the beginning of a longer discussion. Ask for a $4MM cap at 25% discount, and work your way down from there if you are refused. While that's happening you need to explore other options: 1) Find a better offer (get competing offers), 2) Position your company in such a way that you can afford to go without funding (firing people, cutting expensive programs), 3) If you're desperate you'll have to bite the bullet and take the deal.

-Keep in mind that if you don't get better offers and can't negotiate a better offer, and if there is absolutely no way your company can survive without funding, then obviously you need the funding.

-I'm not able to refer you to a lawyer, but keep in mind that you should involve a lawyer in the negotiation. Your friend probably knows more.

Other points:

-Why the hell do you have 8 full-time employees? How are you paying them? How can you justify that expense? What kind of business are you running that has such a high burn rate?

-Can you raise money from non-traditional sources such as family & friends?

-Are you actually truly pre-revenue (as in negligible revenue)? If so, that again begs the question as to why you even have 8 employees and expensive marketing referral programs. Those are not things you do without already having lots of funding.

-Since you're "pre-revenue," why do you even think you've found product-market fit? Is it your daily active users number or monthly actives?

-I wouldn't consider a $250k exit a "proven track record of building and exiting companies." Though it is a positive for investors, I don't think investors would consider it a proven track record.

[narayankpl]

New to term sheet...

Can I ask what does discount mean in this context... "$4MM cap at 25% discount"

[throwawayuc]

It means if another future investor makes an investment where the pre-money valuation of the company is LESS THAN $4MM (like, $350K for 10%), then the initial investor's shares would convert at 1.25x the rate of the new money coming in. So new investor would get 10% for $350K while past investor's convertible note would convert to 12.5%.