Should I raise money with convertible notes or equity?

After “should I form a corporation or a LLC?” this is probably the question I get asked most often. I thought I’d to try to offer a quick, simple overview, with a few links for those with an interest in the gory detail. Here goes. This is general information, not legal advice, capisce? (Duh.)

For the uninitiated, let me frame the issue: you want to raise capital for your startup. You can:

1. Take money from investors in return for preferred equity in the company. (Equity = ownership interests, corporate stock or LLC units. Preferred equity = the investors get all of their money back first, before profits are split according to percentages of ownership.)
2. Borrow money from your investors, in return for convertible notes that flip into equity down the road when you do your first equity round, per #1. The investors are almost always compensated for taking this early risk by getting a discount when the conversion takes place. E.g., if the new investors get equity at $1 per share, the note holders convert into equity at something like $.80 per share.

In my experience, convertible notes are more common. Why?

1. It’s quick and easy to get done. At goodcounsel, we can do this in a day or two, generally for a few thousand dollars at most.
2. It defers any negotiations or decisions about valuation until a later time, when actual business metrics may make the value of the company more clear.
3. As the Venture Hacks guys explain quite well, in most situations the math of convertible notes generally works out favorably for company/founders who can increase value quickly.

If you are dealing mostly with friends and family or other investors who are likely to work with you on the basis of trust, convertible notes will likely be acceptable. VC’s and sophisticated angel investors, on the other hand, look disfavorably upon convertible notes (e.g., Fred Wilson, Seth Levine). Their main arguments:

1. An equity round gives the benefit of a (presumably lower) valuation to your earliest investors, who are taking the most risk on you, and it aligns their interests with yours, because equity owners want to see the company secure a higher valuation in the next round whereas convertible debt holders, at least in theory, want the next round to be at a lower valuation, since they will convert to equity at that lower price.
2. Seed equity documents shouldn’t be all that expensive. (I agree – goodcounsel can get these done for less than $10,000, however, I’ve seen startups pay ridiculous amounts for equity documents.)

There is no single “right” answer here. As a purely practical matter, startups are extremely cash strapped, and the ability to do a small round for a few thousand dollars is awfully compelling. We all know that many startups raise seed money when they are still extremely immature businesses, and a good number won’t ultimately survive. It doesn’t make a lot of sense to spend more money and time on a small seed round under those circumstances.

However, I think there’s a lot to the argument that you want to be economically aligned with your angels. It motivates them to help as much as they can, plus, these are usually people you know  well. You want them to fully share in your success.

My take is this: use a convertible note when you need to raise a small amount of money, inexpensively, to buy you a few months to prove the business concept and get quickly to the point where raising a larger round becomes feasible. When you raise a larger round a few months later, your convertible note investors will still get a reasonable valuation, their discount will fairly compensate them for a few months of greater risk, and you won’t mind spending a little more time and money to get it done.

As with all questions like this, I always tell people that it’s an important issue, but not one that should distract you for very long. You’ve got a business to create, and time is your most precious asset. Neither decision is wrong, so make the decision and move on.

——

I did not cover, above, the ways that convertible note rounds can be made more “equity-like.” The how’s and why’s of price caps are explained well by Brad Feld, among others. Price caps are okay, but then — as with a recent client experience — a smart founder will want a corresponding “floor.” (The price cap protects the investor on the upside, by placing a maximum valuation on the later conversion, and the floor protects the company/founder, by placing a minimum valuation on the later conversion.) Once you start going down this road, my view is that you start losing the advantages of the convertible note, and you might as well just go with a priced equity round.

UPDATE 9-14-12: For those interested in understanding these issues in horrific detail, I see that Mark Suster has a detailed post out on the subject (hat tip: Technori). Some interesting and quite valid perspectives there, and in the comments too. My take is that — outside, perhaps, very sophisticated VC’s negotiating with very sophisticated founders over very significant rounds —  it’s just not worth the brain damage getting into it at this level. Maybe if you’re a VC who negotiates deals for a living…

Categorised as: Capital Structure, Frequently Asked Questions, Startup Stuff