Tl;dr: Convertible notes are used for early-stage startups and for bridge loans. They are debt which can convert into equity in future. There is a reading list to understand more
I had three consulting calls this week with experienced business people that didn’t grasp what convertible notes actually were, so I’m going to spell them out briefly. If you want to nerd out, I have a number of blogs to get the details.
Normally, I write long ass blogs to really teach. This is purposefully a crash course. OK!?
Examples of not understanding convertible notes
Family office raising a small VC fund
I was chatting with a dude in London that has a family office and is now looking at setting up a biotech fund. He doesn’t quite have the clout to set up a full fund, so he wanted advice on ways he could structure a fund.
One idea he had was to raise a convertible note.
You don’t do a convertible note for a fund. What is the note converting into exactly, at what valuation and how does that discussion go? I have no idea. You don’t do it.
With that off the table, we discussed other potential fund structures.
An experienced founder that hasn’t raised before
I get a lot of 40+ founders reaching out. They’ve had exits, but they bootstrapped and are raising for the first time. They’re sort of aware of structures, but don’t actually know what they do nor how they work.
I had a call this evening with a chap on the East Coast that was contemplating if he should raise now, and if so, how? We discussed the optimal share structure etc. He wanted to specifically know how the convertible note fitted into his cap table.
This is a fundamental misunderstanding of what a convertible note is.
Convertible notes are debt that can convert into equity.
They aren’t on your cap table till (and if) they convert into shares.
A new founder looking to raise his first round
This founder has a basic product up and it’s getting some downloads. In this case, he just doesn’t know when to raise, with what structure, how much etc.
That’s fine. It’s just a matter of learning how things work.
The basics are fairly easy to understand (If I teach you), but the devil is always in the details! Actually understanding the math etc, just takes a lot of time.
Here we had to go through what actually made sense and why. There was no simple answer.
What the heck are convertible notes, why and when should you use them?
Let’s go through this at a basic level. Most of my blogs are huge, so I want to keep this one as a taster so it’s quick to read.
What are convertible notes?
A convertible note is like an IOU that doesn’t have to be paid back, but if you do it is in shares when you raise again. That’s the simplest way I can explain it.
Here are characteristics to understand the important parts:
- It is not equity. This is a loan which can convert into equity
- They don’t change your cap table: It’s debt so nothing has happened to your cap table (till the future)
- It converts into equity (hence convertible note)
- It converts into equity at a “qualified financing round”. Say you raise an angel on a note and do a priced round at your seed. Your note converts into equity at the seed (Assuming you raise the $ threshold and whatever terms you may have agreed)
- They are not personally secured! I’m sure founders have secured notes on personal assets, but never do it!
- Legal docs are shorter than a priced round: Docs can be a few pages as opposed to dozens and several
- There legally needs to be a maturity date like normal debt when an investor can request it to be paid back. What happens is not what you think:
- [You are doing bad] If you have money at the end: Let’s fact it, the money is spent. If you have cash left, you can return it to investors if they request it
- [You are doing bad] The money is spent: There is no recourse. You’re shutting down
- [You are doing really well]: You probably have raised by now, so the debt converts into equity and the convertible note disappears
- [You are doing OK]: They may invest more money and extend the note, by mutual agreement.
- The normal main terms are a “cap” and a “discount”. You can have an uncapped note, but they are less common
- They ‘can’ be cheaper and faster to do than a price round. If you use template docs, they’re pretty easy
- Convertible notes are easy to understand the basics but can get really complicated if you let them. You can do things such as “rolling notes”
- Not all investors like them or will do them
Who uses and when to use a convertible note?
Early-stage startups are the ideal candidates. Angel is the best, seed (if not too large is fine too).
They are great if you are raising (most cases) less than $1.5m.
Startups all around the world do convertible notes. The legal docs are almost identical (there can be some minor differences).
You also use them when you are doing a “bridge round”. Basically you are between say, seed, and series-a. You are passed your second seed but don’t have the traction for a full series-A. So you ask investors (normally existing investors) to ‘bridge the gap’ (hence the name) to get you to your A. All investors HATE doing these (at least on favorable terms) as you are a ‘sidewards deal’ (You aren’t killing it). You’re not dead in the water, but you’re good enough to take a bet. It’s much more complicated than this, I just want to keep this light…
Funds don’t raise convertible notes, unless for esoteric reasons even I’m not sure about.
Why should you use a convertible note?
The main reasons to use a note of a priced round is:
- Valuation: You have no clue what it should be and investors can’t agree either. So you kick the can down the road and agree you’ll figure it out at a priced round
- Little traction/early stage and investors get notes: You’re built something and maybe have some downloads. The team is solid etc, so people will chuck some cash your way. There’s no way to value what you have so what’s the point in trying? Angels get it and notes are normal. So you do one. Simples
- Cost: Convertible notes used to be way cheaper than a priced round. Series seed docs changed this, as well as lawyers getting their shite together and reducing the eye-gouging at early stages. They can be cheaper than a series seed or normal full seed docs raise
- Speed: If you do boilerplate and don’t change terms, you can in theory download docs of the net and boom. We can meet in a bar and have docs signed in under a minute (in theory). I always recommend using a lawyer as you don’t know anything and messing up something “small” can cause you real problems
- You don’t have a big investor: Most startups would love one big VC to do your round. Most starts need to hustle and cobble together money from whomever they can. The average number of investors in a convertible note is 13
- You know fancy stuff: Rolling notes are a way of getting money in the bank before you herd all investors together
When should you NOT use a convertible note?
Don’t use a note when:
- You are raising a lot (More than about $1.5m): Investors don’t really love notes. When you raise a lot, investors don’t care about you as much. They like to know how much they own. Convertible notes are sort of like call options for them to invest more money in a future round (If they are a rich angel, or are a VC with money)
- You are later stage: Just do priced rounds. Investors won’t do it anyway
- You are not a startup: It’s weird I’m saying this but I got asked…
What about SAFE notes?
Ok, SAFE notes are a Bay Area thing. Yes, they have been duplicated in other continents, but they’re not normal.
If you want to do a SAFE, then you do the ‘old’ pre-money SAFE, not the new post-money SAFE.
The pre was founder-friendly, the post is investor-friendly.
SAFE are simpler than convertible notes and (if in the USA) can literally download them off the Y-Com site and just use them (Again use a lawyer, some % of you will feck up the basic stuff like not understanding the discount rate and inverting it).
If you can get investors to sign a pre-money note, kool and the gang.
Otherwise, I prefer vanilla convertible notes as you can do more things if you understand them (and investors don’t).
Reading list to understand convertible notes
If you want to get your shite together and understand all of this in more detail, here’s my free resources and blogs to read.
Understanding how priced valuations work
Understand post-money SAFE docs (The ones you don’t want to use)
Conclusion on convertible notes
Ok, that was a crash course!
If you have comments to add basics to explain them to n00bs better, please shout out in the comments, but I want this to be the super basic “Ok, I get what a convertible note is and is not” version.
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