Should I raise a Seed round on a note?
Photo by Johny vino on Unsplash
This piece was originally posted on my personal Medium page, prior to joining Fly. My perspective on this still holds, though I should note that this position does align with the Fly investment style.
The note vs. equity question has come up more and more as of late. The debate takes form when a founder goes out to raise by a round (assuming priced) but receives a VC-led convertible note term sheet instead. It’s a trend that is becoming more and more popular in the markets I work in. At face value many founders believe that notes actually have the advantage. “Faster cash, easy legals and we don’t have to haggle over valuation” is the default thinking. If only things were so simple…
Based on the deals I’ve worked on the convertible note fanfare is flawed thinking. Notes can be far more damaging than most founders realize precisely because of their perceived simplicity. While you may save yourself a few weeks of legal headaches, the price can be hefty and irreversible when the bill comes due.
Q: Should I raise my Seed on a note?
A: Almost always no. Equity > Convertible Debt
This post is an explanation of why.
A quick recap for those newer to these instruments. Equity means direct ownership of some portion of your company, just like a share stock in a public company. A convertible note is a debt instrument (or a loan) that is designed to defer repayment until it ultimately converts that accrued value into equity, at a later date. Notes by themselves are not a bad thing. When used as they were originally designed for, a short term bridge to a larger round, the instrument makes a lot of sense. But when a note is the round the terms of it reach a breaking point. To understand those terms requires some tricky math, so many go unnoticed until years later when everything converts. At that point founders, and sometimes even investors, come to realize that they’re far more diluted than they anticipated.
If you find yourself with a convertible note term sheet, here are the things you need to know:
Speed; the false promise: By far the biggest advantage that you’ll hear is that notes are much faster than doing a priced (equity) round. A faster raise means less time schmoozing investors and more time building your business, right? In my experience that has just not been true. When you’re raising an entire round on a note you are likely to have nearly all the same stages as you would with a normal round. You still negotiate on valuation, just now it’s a cap. You still go through due diligence. You still need to coordinate with all your investors and sort out allocation. The only stage that is reduced is the actual legal filings, because you don’t need to bother yourself with same share agreements (investors won’t yet own any shares). If you’re a startup in the Valley where competitive pressure is at an all time high the speed argument might be true. But in both London and Singapore I have had to work through convertible note deals, led by a VC, which took well over 6 months to close.
Side note: Just this week I was thrilled to see a note-driven deal close within a few weeks of issue. This was led by a particularly aggressive Valley VC, so my viewpoint may not be as relevant in the US where notes are far more commonplace.
Interest Rates; the valuation discount: A loan is financial instrument that makes money in one way: interest. A lender gives money today with the promise that they’ll be paid back in full plus a little on top for their trouble. It’s a pretty simple idea that most people are familiar with which is why you see it in student loans, auto financing and mortgages. With convertible notes the interest is deferred so you never actually pay money back to the lender (investor). Instead your “tab” just grows in the background until you eventually raise a round. When it does come due it takes the form of increased equity which can form of a much different cap table than expected. Here’s a simple example:
Let’s say my fund leads a $1.5M round in your startup on a convertible note. For simplicity let’s assume there is no cap or discount. The only term is that the note carries a 5% deferred interest rate. Fast forward 24 months and you raise a $5M priced round on $20M pre-money from a Series A VC (congrats!!). So what am I owed? $1.5M / $25M = 6%, right? Wrong. Because I my note accrued interest my actual investment is worth $1.65M ($1.5M * 1.05²). That means that my actual ownership is 6.6%. An extra 0.6% isn’t going to break the company of course, but that’s a senior exec’s equity package!
It’s not impossible to have a 0% interest term in the note, but I’ve seen 5% — 8% much more.
Valuation Caps ARE Valuations: There’s all too commonly held belief that notes are easier because you don’t need to negotiate over valuation. If you have a term sheet that is uncapped this is true. But having seen hundreds of notes within my years in venture I’ve known of only one that didn’t stipulate a cap. This is for good reason. Not having a cap kind of screws over investors for taking early risk. With a cap they have some minimum expectation of ownership. [Pause for a second] A guaranteed ownership floor….sounds a lot like a valuation, right? Let’s return to my previous example. I invest $1.5M on a note, this time with a $8.5M cap. Two years later you raised the same Series A ($5M on $20M). What am I owed? My original investment converts to equity at the lower of the valuation cap or some discount of the later round (almost always 20%). My $1.5M invest won’t convert at the $20M Series A price, it flips at the $8.5M cap that we agreed to. So in addition to the 20% you gave to your Series A lead you also have to hand out the 10% equity stake that I was owed from our investment 2 years early. When you raise on a note with a cap you’re putting a price on your company, you just don’t “feel” it yet.
Liquidation Overhang: By far the least understood element of a convertible note is the multiple liquidation preference that they get an investor through the backdoor. The math can get a little tricky, but this article by Silicon Hills Lawyer does a nice job of explaining it all. I’ve borrowed their words below:
$500K seed round with notes carrying a $2.5MM valuation cap.
Series A has a $10MM pre-money valuation, resulting in a per share price for new money of $4.00.
The Series A has a run-of-the-mill 1x participating liquidation preference. This means that the Series A have a per share liquidation preference of $4.00.
The $2.5MM valuation cap means the notes convert at $1.00.
Under the above example, the $500K in notes will convert, ignoring interest, into 500,000 shares. $500,000 / $1.00. If the Notes convert directly into the same Series A preferred stock as “new money” investors get (which is what most notes require), their aggregate liquidation preference is $2 million. 500,000 shares * $4.00. So those investors paid $500,000, but they have $2 million in liquidation preference. In other words, they got a 4x participating liquidation preference. The $1.5 million difference is the “liquidation overhang.”
A reputation would be crushed if a VC pushed a term sheet with a 2x+ liquidation preference in a priced round but it happens all the time with convertible notes. Unless a note has a split class conversion (part preference/ part ordinary) accepting a note-based round signs up for founders a much higher floor than they might realize.
Q: Are notes ever ok to use?
A: Of course! There are times when the benefits outweigh the costs. It’s totally fine to use a debt instrument if:
You’re raising less than £300K. At this capital the interest rates and liquidation stack just doesn’t make that much of a real impact.
If you’re raising from a bunch of people. The biggest benefit of a note is that you can do independent transactions, like selling a product to different customers. No coordination required! Gathering signatures from 10+investors can be quite a test of patience so in these cases notes have an edge. Note: it’s still strongly encouraged that you raise on the same terms and valuation cap, otherwise understanding ownership becomes very tricky very fast.
If you’re raising a bridge. This was the original intent of the note and still its best use case. If you think you’re going to raise again in less than 6 months and don’t think you’ll see more than a 30% increase in valuation between now and then you’re all good.
Q: What do I do if my lead wants to use a note?
A: You’re about to enter into a relationship with this person for 5+ years, so you might as well start off by being honest. Express your concerns, indicate your preference for equity and hear their reasoning for this instrument. In my experience most investors are pretty open to making a deal work. I’ve seen many of the tricky terms I’ve described get removed without a second thought. Some may even switch completely.
In my experience investors don’t use notes to be tricky or unethical. Many I’ve spoken with use notes because they think it’s what founders want. The truth is a standard note is a well-intentioned instrument that has been stretched too far and is no longer fit for purpose. It’s easy to fall down the rabbit hole of game theory and negotiation tactics. Ultimately though seed investing is very much a people business. If you aren’t comfortable having this conversation they probably aren’t a great investor for you in the first place.
Q: What do I do if I only have one term sheet and it must be a note?
A: Negotiate hard and take the best you can get. As the CEO you have one job above all else: make sure the company doesn’t run out of money. While a note deal may not be ideal, you have to play the hand you’re dealt. As the saying goes, a big ownership stake of nothing is still nothing.