Should you raise on convertible notes or do an equity round?

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A reader named Turner Dean recently asked me whether it’s better to raise seed money on convertible notes or straight-up equity.  Since this is a hefty topic that we could discuss for days, in this post I’ll aim to cover just the pros and cons of each from a founder’s perspective; I will NOT cover:

  • What is a convertible note, equity, or convertible security?
  • What major terms you should look for, be aware of, and ask for?

There are a ton of other blogs out there that will cover these two topics in great detail.  My expectation is that you’ll check out some of those other resources first if you’re not familiar with any of this.  Just do a Google search.

In general, I’m a big fan of convertible notes and convertible securities for seed stage founders.  These are the big pros; they are:

  • Cheap
  • Quick — you can start bringing in money immediately
  • Flexible — there’s no such thing as a round, so you can start and stop raising at any time

Cheap

Because convertible notes and convertible securities are basically standard — in fact, if you’re not using one from the internet, your lawyer (at least most lawyers in Silicon Valley) should be able to provide you with a free template that you can modify —  these should be basically free.   I think my total legal bill for getting my seed round done for LaunchBit was < $3000.  In contrast, if you do an equity round, you as the founder will often have to pay $20k-$50k in legal bills.  You may also be on the hook for your investors’ legal bills, though this is changing a lot these days.

Quick

Once you get a convertible note signed, you can ask your investor to wire you the money or send you a check.  You can start bringing money into your bank account right away and can start deploying it immediately.  In contrast, if you do an equity round, you have to complete the entire round and go through the full due diligence process before anyone wires you money.  This process can take a couple of months.  Frankly, in my opinion, if you’re a fast-growing startup that’s deploying capital into your growth process, you really can’t afford to wait months.

Flexibility

In an equity round, you’re raising a specific amount of money.  With a convertible note or a convertible security, while there may be an upper bound to a note, there’s no fixed amount that you need to raise.  You can always create new notes easily if you need to raise more money or raise an amount less than what you intended under your existing note.  Flexibility is good because you may want to change the nature of your round as you see what the uptake is.  If you have great uptake, you may end up wanting to raise more money on another tranche of notes at a higher cap.  If the uptake is bad, you may want to wrap up your round shy of your initial target round and go back out into the market to raise again later once you’ve made more progress.

In reality, it almost doesn’t make sense to do a priced round at such an early stage because you don’t know what the fundraising landscape will be a priori.  You may not know what you’ll be able to raise or what makes sense to raise before you start.

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Originally posted by inspiring-dancers

Cons

Jason Lemkin has referenced a lot of the cons of doing convertible notes and convertible securities in his blog post here.  Namely:

  • Investors spend less time with you, feel less committed to the company, and won’t help you as much with your next round
  • Your legal bill will be higher when you have to sort out all of your notes later when they convert to equity

Investors

A big reason investors feel less committed when they sign convertible notes is that they don’t know what their stake will be in the end.  Downstream investors can potentially rewrite a lot of the conversion terms later, screwing over earlier investors.  This happens more than you might imagine.  So, early stage investors tend to be more wary of convertible notes and convertible securities.  Some early stage investors, especially outside of Silicon Valley, still won’t do any deal that is on a convertible note or convertible security; if you’re not based in Silicon Valley, this is something to consider.  Despite this, I still think convertible notes and convertible securities are founder-friendly and worth doing as an investor.  The bigger lessons for us investors are probably on trying to steer founders away from piranha-like, downstream VCs.

Sorting out all of your convertible notes at what caps, etc., will become a bear when you raise your first equity round.  This is especially true if you follow the tranche strategy of which I’m a big proponent (more on this later).  You’ll pay for this later when you sort it out with your lawyer.  That being said, I still think it’s better to raise money in tranches on a convertible note or convertible security and defer your complicated conversion to equity later.  I see this a bit akin to technical debt.  As a startup, you often need to do what is best for you now in the quickest, scrappiest, and cheapest way possible, otherwise you just won’t make it.  We hold this to be true in product development, and it should also hold true when raising your seed round.  You just don’t have time or money to worry about making things clean now.  When you have more resources later, you will pay for it.  And that’s ok.  If you get there, big props to you.  Most companies never get to a true series A equity round and never have to worry about this deferred legal bill.

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Originally posted by leveraged-buyout

While there are a lot of pros and cons to raising on a convertible note or convertible security, if you are based in Silicon Valley, I think it makes a lot of sense to do so as a founder at the seed round.

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