Yesterday I was speaking with an entrepreneur with an exciting company and terms structured as a convertible note. Convertible notes are non-starters for my angel group, as they are for many (though certainly not all) other groups. Why?
Convertible notes have numerous advantages, the biggest being lower legal expenses while dodging the emotionally and intellectually infuriating valuation fight for early-stage companies.
But it is the disadvantages that bother my angels. Some of the biggest being:
- If you look at the internal rate of return from the time of signing the note to when it converts, it is usually dramatically lower than the 60% equity investors are targeting – despite the fact that note investors are usually the ones taking the most risk.
- If the note signers help the company explode between now and the series A, they get the same benefit as if they did nothing to help grow the company. This can be mitigated somewhat by a cap… but only somewhat. In other words, the note does not align investor and entrepreneur interests .
- All old terms are always up for negotiation when new investors bring in new money. But de-facto, my (admittedly anecdotal) queries show that new investors have much more success negotiation down terms from notes than terms from prior equity rounds.
That’s my take.
Here are some others who also dislike convertible notes:
- Xconomy wrote up a detailed piece on reasons why entrepreneurs might want to avoid convertible notes here.
- Don Dodge, a respected member of the Northeast angel community had this to say.
- Basil Peters, a nationally recognized thought-leader in the angel community isn’t a fan either.
If folks know of some people who do like these notes, please let me know so I can fairly link to them. A quick search for me came up empty.