[pbiggar]

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.

[ganeumann]

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.

[pbiggar]

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.

[ganeumann]

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.

[g42gregory]

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.