Bad Notes on Venture Capital
bothsidesofthetable.com
bothsidesofthetable.com
Convertible notes and convertible equity (SAFEs) both allow founders to meet these goals in ways that equity rounds simply do not. In this sense, they have incredible value as tools to be used by an early-stage startup.
Are they perfect tools? Well, no. Each has its own limitations and problems and each can be abused on either the company side or the investor side. Founders routinely used to take uncapped convertible notes, build value, stretch out the process, and leave the investors getting ever-diminishing rewards all the while that their money was being used to build that value. Investors wised up and began insisting on caps to avoid such abuses. They wanted to protect the idea that they would get significant extra rewards for taking the earliest-stage risk. It was not enough, e.g., to get a 20% price discount at Series A if you convert at $20M pre-money valuation when the company was probably worth no more than, e.g., $5M at the time you invested the seed money. The investor insisted on locking in that ceiling on valuation as a means of self-protection. Does this result in occasional windfalls to bridge investors who take capped notes (or SAFEs)? Yes, it does. Does this arrangement have attributes of something that resembles a liquidation preference in its functioning? Well, yes, it does. Ditto for the full-ratchet anti-dilution attributes. These things are very real attributes that do affect the value of using these tools for founders and their companies. They add to the negative side of the ledger.
But let us say that your startup had to give four times the value in Series A preferred stock relative to other investors to the hypothetical investor noted above ($20M valuation, $5M cap). What does this mean? If that early investor put in $300K and the Series A round was for $7.5M, the early investor might have gotten a windfall but the impact on the round is small because the dollars involved are not large. And if the venture did not do well and the Series A round priced at $3M, then that same investor would still get something like a 20% discount off the lower valuation instead of having had to peg his fortunes to the $5M value used for the cap as he would have had to do had he taken equity. But so what? The dollars are still small and it doesn't matter relative to the value and utility offered by using the convertible note (or SAFE) tool. And, for every "windfall" gained by such investors, you have all sorts of cases where the failure rate is particularly high because of the extreme risks existing at the earliest stages before it is even determined that a company is truly "fundable."
The value of notes and SAFEs is flexibility. Your occasional investor will get special advantages but these are not unduly costly to you as a company. And you have a good measure of control over how you do things. Your first note can be capped but, as you gain traction, later notes can be uncapped. You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing. You can do the number of notes and in the amounts you immediately need. You don't have to go through endless negotiations over the sorts of things that can accompany an equity round (especially protective provisions and similar restrictions on what a company can do). You avoid giving your new investors a veto right or other significant say on what you can do in future rounds, as you would normally have to do if you did an early-stage equity round using preferred stock.
Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round. And, in most cases, it is a useful and valuable dynamic for founders and their companies notwithstanding the trade-offs. In this sense, the main idea of this piece that I would strongly disagree with is its suggestion that using convertible notes is somehow a sucker deal. It can be if done wrong but it most often is just the opposite.
Another metric for measuring the relative value of these tools is to see who is using them. Convertible notes have had massive and widely dispersed use now for many years. The most sophisticated investors have had no problem with them in general, and that includes the VCs who lead Series A rounds in which converting noteholders get the benefits of their caps and take more relative value in the round than the VCs themselves do.
As with anything else in the startup world, founders need to use good judgment. The points made in this piece are informed and technically accurate. And they do underscore some clear disadvantages in using notes/SAFEs. My point is that, notwithstanding these defects, notes/SAFEs retain great utility for founders in the context of the broader issues they need to address (minimizing tax risks, keeping stock price low, keeping transaction costs down, etc.). And so this is a good piece to add to your knowledge base but it should not deter you from using non-equity forms of seed funding as long as use of these tools meets your bigger goals. You have control at that stage. Use that control wisely.
> You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing.
If you raise a note with an $8M cap, it might not have the same impact on tax and equity pricing as an actual equity round at an $8M valuation. On the other hand, I wouldn't say the impact is zero. A share of stock in a company that's raised a convertible note is arguably less risky than one with no cash period. And while you're not necessarily legally obligated to raise above the cap, it certainly anchors expectations for future rounds. Even if there isn't a cap, there's some anchoring going on based on the amount of money raised -- i.e. if I raised $2M in notes, it's going to feel weird to raise less than that in a Series A. And to the extent that investors have expectations about the percentage of a company they want to own, anything that affects the amount you expect to raise affects your Series A valuation.
> Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round.
Note that the dynamic is technically orthogonal to which instrument you use to raise. You could (probably) draft a simple seed stock issuance that functioned similarly to a SAFE with a cap (e.g. preferred stock, 1x liquidation preference, and pull-up rights) in terms of transaction costs, flexibility, etc.
Practically though, this doesn't happen often. Again, the issue is really about anchoring. If you're going to issue preferred seed stock, you have to put some kind of language down about the rights of that stock. And while this language can always be amended, what you put (or don't put) down has the psychological effect of anchoring the Series A discussion.
The deal was relatively quick and easy, and under $10k in legal. Even dealing with the SEC was quite pleasant. Ultimately I like the directness and simplicity of preferred shares. It also helps when back in 2012 we got the 100% federal capital gains exclusion on QSBS.
Regarding keeping a low stock price; your limited offering preferred share price has little-to-nothing to do with your common share pricing. It should be trivial to get a safe harbor'ed common stock valuation at PAR for 83(b) purposes, even following a $3-$5m pre-money seed round.
Explaining how SAFEs work in the context of the actual process of raising money - meeting with investors, figuring out a price, needing to raise more etc was eye-opening and very useful.
Thank you again for all your comments here!
My understanding -- limited, in that I've been a party to two but from the other side of the table -- is that a major reason they became popular is because they take the fangs out of collusive behavior by investors. The Valley had evolved a "Well, I'll invest if you get a lead" "Well, I'll lead if you close $X" system which froze out a lot of companies if the founders didn't have deep, pre-existing social networks. "You want a lead!" sounds a lot like wistful nostalgia for this gatekeeping behavior. I understand why a gatekeeper would see it that way. I don't understand why the gated would.
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.
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 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.
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.
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.
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.
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.
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 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.
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?"
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.
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.
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.
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.
Kinda, but in a different way. When we were raising our Series A round, some investors based their offer off our Seed round's valuation. One investor thought that our seed round was a capped note, and wrote us a term sheet that was a "generous increase over your cap" (I think 20% perhaps). I think if they had known the seed was a priced round, they would have made something more like a 100% increase over it's valuation.
In particular, what Suster says about the importance of having a lead rings absolutely true to me. My investors were a huge help when figuring out a complicated merger that eventually led to a terrific outcome. If I had raised from a big bunch of smaller, not-particularly-invested angels instead - well, who's to say, but I suspect I would've botched it.
That said, Mark seems one of the guys that really likes to help entrepreneurs. I read his post not as "Don't ever do a note" but "be very aware of unintended consequences". As I am starting to fundraise for a new company, I've felt incredibly uncomfortable with convertible notes for the reasons Mark outlined in his post. I thought I was being paranoid since everybody is saying notes are the way to go, so it is nice to read an opposing view.
One major problem with convertible debt in that it is fundamentally debt with an X year term and Y% interest rate. If the startup chooses not to raise further capital, the note does not dictate what is done (at least ours didn't).
This isn't much of a problem if your investors are really nice, smart people. But if they aren't...
I've had the experience of a non-entrepreneur-friendly investor calling the debt (e.g. demanding repayment after the term had expired) at a time when our startup couldn't make a payment of that size. They refused to extend the term. The investor then threatened to liquidate the company if we didn't pay them back.
Some of my cofounders had made money in the past, so we repaid the debt by having them lend money to the company. But I'm not sure what we would have done if we didn't have that option.
I've taken it for granted for the past 3 years now that convertible notes were universally regarded as the best and smartest form of fundraising for seed rounds, just based on what I've found and read in various places online (lots of it here on HN, for that matter...)
And here we have Suster laying out clearly the opposite side of the argument in a way that humbles me. This is clearly an area that I have a lot to learn from people much smarter than I.
Most YC companies go on to raise rounds using YC's SAFE, which is an adaptation of convertible notes, right? If so, I'd love to hear a YC partner (or partners) address these points.
This article is simply a warning that using a convertible note without any consideration to potential consequences in future rounds is a bad idea. A convertible note isn't necessarily a free pass that lets you say, "I don't have time to figure this all out right now" -- if only anything were.
There are a few ways you can screw your company up raising convertible notes; there are a million ways you can screw your company up raising a priced round.
At the end of the day, you have to have good mentors and lawyers to make sure you're not doing something stupid while you worry about building your company. As Mark Zuckerberg said at Startup School, and I may be paraphrasing, "The biggest mistake a startup can make is worrying about all of the mistakes they could be making." There's no way to get through unscathed, so have people who understand it better than you to make sure you're killing the closest snakes, and keep building a great company.
The truth is that notes and YC's SAFE are still the way to go. Why? If the startup is taking off, then you're going to blow past your cap (which you should set fairly) and everyone's happy. If the startup isn't headed anywhere, well, why the hell are you raising more anyway? Consider selling or shutting it down. The problems he's pointing out apply in this case, and frankly you can always in such a situation consider re-negotiating prior deals if you have to. In other words, these are theoretical objections at best.
Most 'traditional' investors used to have it good in the (good, according to them) old days. They had the leverage, so they forced terms that were good for them. This meant lower valuations in general compared to today, and control in the form of board seats, which you generally had to have once you had different classes of equity. Those days are long gone, and this strikes me as a lament for the way things used to be.
The average return for companies that start as a cap and not equity is < 1.
Companies that have sufficient success at the time of raise do not generally do debt. YC biases them more towards notes, though.
The trend toward notes is easier, but not better for startups.
BTW: By "average" I mean that the sum of dollars invested versus the sum of dollars returned or marked to market.
I suppose one take-away for founders could be to beware the signaling risks of taking convertible debt if you are, in fact, good enough to raise a Series A. Another might be to do everything possible to get traction before running out of money. Both of those are fairly well-known already, however.
Would it be fair to say that the stronger companies also tend to have either (1) strong fundamentals (i.e. historic financial numbers to base a valuation on) or (2) rapid growth (i.e. the future is clear and the network effects are clearly on the horizon).
My general assumption is that most angel deals are done "pre-curve" and equity deals are done during the curve. Every investors wants to be during the curve as it's the highest upswing in short term returns.
The better argument here is probably - why are angels even entertaining debt deals then?
Small investors don't have access to Series A. That's why the analogy with the stock market is broken:
"Can you imagine investing in the stock market where your price was determined at a future date and the better that company performed the HIGHER the price you paid for that investment."
The reality is angels don't have the option of purchasing the stock after the seed round. So, it can make perfect economic sense for an angel to pay a premium to get access to a deal. And if that premium comes in the form of pre-paying for a chunk of the Series A (one way to look at a no-cap deal), that can make sense -- perhaps even more sense that an enhanced seed valuation would. A discount would be sweetener on top of that. But to be clear: there is a rational case for smaller investors taking no-cap deals in order to get a chunk of the next Facebook, which they otherwise wouldn't be able to get.
Seed rounds present a unique intersection point for founders & smaller angels where their interests overlap. I think the bigger-sized investor community are somewhat threatened by that, and that's why we're seeing such a sophisticated campaign against no-cap convertible notes. But the climate is now competitive enough and small-angel platforms are getting enough traction that you can sense their anxiety that no-caps may be coming back, to the great benefit of founders.
I never thought of it that way, seeing series 'A' with some regularity and being a (consulting) participant in the deals I never felt the urge to invest in these deals simply because that would create a conflict of interest. But the fact that the only investments that I did do were as an angel in 3 different companies was simply due to the fact that the rounds were very early and the amounts were still low enough that they were in my 'bracket' or 'comfort zone'.
I guess if I felt the need or desire to participate in series 'A' I would join an established VC as a limited partner.
One of the reasons VCs would not like to have a bunch of angel investors join in a series A is that there would likely spontaneously combust into existence a sort of Polish Parliament and then the deal would likely fall through.
Syndicated deals have some of these aspects already, especially if the geographic and/or cultural spread of VCs is large.
Superangels / mini-VCs / actual VCs like Suster don't find it as appealing because they have plenty of Series A deals come their way.
But then again I bet they would bite at a really quality opportunity at the seed stage, because the best companies will seek larger funds at their Series A than what superangels can offer. (So they're not necessarily seeing the best companies at Series A.) Part of me thinks this "no cap's for suckers" blogstorm is just FUD to improve their collective negotiating position.
The only thing dumber than a superangel taking a no-cap convertible debt deal is a superangel passing on the next Facebook's seed because they didn't want to pay Series A prices. That would be incredibly shortsighted.
So generally you get just the original price's worth of preferred and the rest is common.
Take a modern convertible note to an angel investor from the pre-bubble 90's and they'd laugh you out of whatever coffee shop you happen to be sitting in.
All of the "examples" shown in the blog post make irrational arguments. Show me one scenario (in numbers) where using a convertible note for a seed round was suboptimal compared to an obtainable equity deal.
If I didn't know better I'd think this was an example of a VC trying to smear an awesome instrument so hopefully they won't have to compete with investors willing to write them.
When raising a full round of capital, say 1M, you don't get any of it until you 'close', after everyone is committed.
Convertible notes allow entrepreneurs to build progressively towards a close, without waiting for all the cash to come in -- which might come too late. So, sure, if you're flush with cash, then convertible notes are a worse idea relative to a priced round. But when is that ever the case when fundraising?
When dealing with smaller angels, its easier to get your first 250k - 500k in 50k-100k increments.
I do like the idea of setting a price instead of a cap. Even if it means your price is a bit lower than the cap, it should be relatively straightforward to transition from a cap to a price with sophisticated investors, and it protects you in any weird situation.
Many note investors also ask that a certain amount be committed before the first close.
Basically convertible notes were kind of a financial hack that let you take money without setting a price by calling it "debt," even though no one really regarded it as debt. That brought along a couple small negative side effects, but the good outweighed the bad and let you close rounds quickly without $10-25k in legal fees and seemingly endless negotiation.
A SAFE is the same thing, but it jumps through the hoops necessary to not be called "debt" and gets rid of those side effects.
Example: Angel invests $500K in startup in convertible note form, startup raises 10M from venture capital firm at 90 million pre-money valuation later. The VC firm ends up with 10% of the equity, because 10 million is 10% of 100 million post-money valuation (90m pre + 10m invested). The angel will receive 500K / 100 million = 0.5% of equity if there is no cap or discount. If there is say a 50% discount, the angel gets 500K / 50 million = 1% equity so double the equity. Same effect would be if there is a cap of the conversion valuation at 50 million, i.e. no matter what valuation the VCs invest at the angel gets at least 1% of equity because 500K / 50 million = 1%.
Hope it makes sense.
I'm starting to realize that my gut reaction to squint skeptically at convertible notes wasn't too far off the mark... it's like going to Vegas and betting your company, but everyone else at the poker table has been playing for years longer than you have...
At the angel stage there are very little metrics and multiples to go by, hence why you need to invest in the team and incentivize them using convertibles.
http://avc.com/archive/#mba_mondays_archive
Start from the bottom and go up (reverse-chronological order). Better yet, save them all into Instapaper or Pocket and read them offline at your leisure. Each article is fairly short yet packed full of info.
http://techcrunch.com/2012/04/07/convertible-note-seed-finan...
http://techcrunch.com/2012/04/21/convertible-note-seed-finan...
anti-dilution: only if negotiated
(http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou...)
So convertible debt isn't really debt-- it's an equity investment with deferred closing and terms. Right?
I can see then how this can lead to bad outcomes for the entrepreneur (behaves like a full ratchet if there's a cap) or bad outcomes for the investor (you've deferred the conversation and agreement on expectations). But at the same time it is in some ways simpler, and you get the cash immediately. Right?
Hmm... this is interesting. He suggests setting a price. So let's say I want to raise convertible debt... he's suggesting that one instead says "I'm raising one million at X" and sell convertible notes with a fixed price instead of a cap? What would that look like?
Glad to see so much discussion about it. After taking Venture Deals with Brad Feld and Jason Mendelson through Kauffman Fellows Academy / Novoed, I'm quite curious about trends on this topic.
Make a product worth something to a target market. Sell it or get enough traction. Find a company who would like to buy you or go public based on your growth.
All this other stuff is a distraction created to keep you from focusing on what you are here for. To build great things and sell it for profit.
Otherwise... whats the point. The best negotiating term is having a great product. You won't raise your way to a product/market fit.
As a founder, I have tried searching for these but never managed to find one.
I'm not sure if it is an India thing, where investors actively discourage convertible notes because of the availability of several pounds of equity flesh in exchange for angel stage funding.
1) If an investor invests $500k at a $4.5MM cap, he signs up to get 10% of the company assuming the Series A priced round will be at a higher valuation. But, if Series A is at a lower valuation, say $2.5MM, then the investor gets 20% of the company. However, if there was a discount associated with the convertible note then the note converts at 80% of $2.5MM. So a down round is really bad for the founder. But I can't imagine a down round being much better for a priced round.
2) If the Series A is $3MM at $12MM pre with 1x liquidation preference, the Series A investor gets 20% of the company. The seed investor who invested $500k will have his shares converted at the $5MM valuation. However, he will end up with a 3x liquidation preference or $1.5MM in liquidation preferences. I think this is okay as long as you raise a few hundred thousand dollar convertible note seed round. If the convertible note seed round ends up to be in the $1MM range I think this can become an issue for the Series A investor which is Suster's main point.
Convertible notes have benefits like high resolution financing, less control & no board seats. I still think convertible notes are the way to go if you are raising a few hundred thousand dollars in seed. But if you raising a seed in the $1MM range, it seems like priced rounds are preferred.
re high resolution financing: if you are offering different investors at different prices, you are likely to make your investors less than happy with you.
re less control and no board seats: in my experience, having a board correlates strongly with success. so i think this is a negative. to put money where my mouth is - for my last startup, I took a board even though I did not have to.
re raising a few hundred thousand or less: in my experience, strongly correlated with startup death.
re less control and no board seats: agreed. though i think it depends on the board member. in your case, i'm sure he was top notch :)
re raising few hundred thousand or less: hmm, don't have enough data. but uber's initial round was $200k. https://angel.co/uber
VC wants to make money off of your work/startup/company.
VC makes money using the given terms.
When it comes right down to it. The money they "give" is not given. It is a loan with terms and conditions. You need to be aware of this. You need to know what a loan is. It is money you are borrowing that you must pay back WITH INTEREST. Find out how much interest that is.
"It’s like we need a finance 101 course for entrepreneurs"
Debt money is bad. I realize a lot of people will tell you that this is how the world runs, or this how they run their business, or I got successful in business taking out a big loan, etc and so on. Like the gambler, they don't tell you about all the losses.
Save your money. Keep your work/startup/company.
http://www.gamesradar.com/nintendo-doomed-not-likely-just-ta...
I've read that Microsoft has always had enough money in the bank to operate for a full year without making any money.
Yes, VCs like to make money, they'd even like to make it of your work/startup/company but the odds are such that they likely will not.
So they will invest in a company for equity rather than as a loan that carries interest and that you can pay back at your leisure, unless it is really early days and so very hard to assign a value to the company (not that that is much easier later on). I Really do agree that we probably need a finance 101 for entrepreneurs, and you probably should enroll. Debt is not necessarily bad, giving out a chunk of equity in return for funds is not necessarily bad. No more than a hammer or an axe are bad.