Convertible notes versus equity debate – my simple take

Fred Wilson (always worth reading) has once again posted some views in the (perhaps a bit tired) debate about whether entrepreneurs should raise seed financing using convertible notes (or their close cousins, SAFEs) or priced equity. (Wilson’s original post was all the way back in August 2010.) Amazingly, though posted only a month ago, there are 98 comment threads (and the comments are closed, otherwise there would surely be more).

Wilson, though a venture capital investor, makes the argument that convertible notes and SAFEs (which are more or less identical for purposes of this conversation) are bad for the founders. I have no reason to think that he’s being insincere or self-serving; he has a good reputation, and he makes some valid points. At the same time, one can find any number of people arguing that convertible notes are a bad deal for investors, and no investor ought to invest through one. Here’s a recent example, from David Cummings in Atlanta. (Don’t know him, but his bio is impressive enough.)

Who to believe?

I’ve posted on this subject before. Re-reading that now, years later, I still agree with myself (Hooray!). Below is a more concise take, as posted in a comment to the Cummings thread I wrote today:

All of these posts [pro and con] tend to ignore the compelling reasons that entrepreneurs turn to convertible notes.

Note documentation is easy to understand (the number of moving parts is quite low) and, most importantly, relatively inexpensive. By contrast, doing an equity round generally involves changes to a company’s certificate of incorporation and — if any of the standard document sets are used (most of which I find to be investor-favorable to a greater or lesser degree) — three or four additional, long documents will also be involved. The legal fees easily get to $20K or more, when both company and investor counsel are included.

Personally, I’ve done much lighter equity documents for startups, quite inexpensively, but these are for seed rounds, where the company tends to be in the driver’s seat and a lot of terms can be left out. I am sure that if a VC investor were involved, they would find them lacking (in their view) sufficient protections.

The problem with equity rounds is complexity and cost, and until those issues are addressed, companies will keep using notes and SAFEs, even if in some cases they have terms that may be less than ideal for one side or the other.

In the comments to Wilson’s post, you will find heavy-duty debate about whether or under what scenarios the dilution mathematics of convertible notes works out better for investors or founders. (Spoiler: it depends.) I simply feel that my take reflects a more practical perspective on why people go for convertible notes. It’s generally not a decision based upon intensive spreadsheet work using a variety of assumptions about company growth and future rounds and valuations; it’s about how to get the round done and the money in the door, quickly and economically. That seems to trump all other considerations.

Categorised as: Lawyering