Convertible notes are pretty popular with a lot of startup founders and investors these days. I understand why: They're simple, easy, and don't come with the same legal difficulties (and legal fees) as offering equity straight up.

They're also incredibly controversial and come with serious drawbacks. To a first-time founder, they may seem like a win-win that gets you cash without putting you or your investor into a crappy situation.

Well, yeah. They seem that way.

Convertible Notes: A Quick Primer

Before I go any further, let me give a quick refresher on how convertible notes work.

A convertible note is something issued to an investor that, instead of representing a set amount of equity now, is intended to convert to equity at the next fundraising round (Series A, usually). Instead of raising $50,000 in exchange for a ten percent equity stake--and thus valuing your startup at $500,000 before you know enough to really do that--your investor just gets whatever $50,000 buys in an equity stake at the next round. If your next round valuation is $1 million, your investor gets five percent equity.

They help you raise capital without needing to define a valuation of your company. It's not actually an investment in the traditional sense of cash for equity--it's technically a loan. Instead of generating the return of principal plus interest, the loan is intended to generate the return of some equity stake in the company, the exact value of which will be determined at the next funding round.

So, this sounds great, right? You get the cash you need, your investor gets equity down the road, and you can move on without spending hours upon hours negotiating and blowing half the investment on lawyer's fees.

Ah, if only it were so simple.

The Problem(s) with Convertible Notes

There are actually so many problems with convertible notes that you could probably write a book on them, but here are two of the big ones:

1. Misaligned incentives.

Fundamentally, convertibles misalign incentives between founder and investor. In an ideal world, you both want your company to be wildly successful and raise a stratospheric Series A valuation.

However, with a note, the founder's incentive is for a high valuation, which dilutes the investor's stock, while the investor's incentive is for a low valuation, which gives them more equity. You're at cross purposes, even though you're on the same team.

Not good.

2. Caps won't save you.

One "solution" is to set a cap on the note, which means that if the company gets a high valuation, the note will still convert into an equity stake at some predetermined max valuation. In our $50,000 investment example, the cap might be set at $500,000--so no matter how high the valuation, your investor still gets at least a ten percent equity stake.

This seems to solve the problem, but it can easily screw over the founder. I don't care what the circumstances are--no investor should be able to pay $50,000 for a ten percent stake in a $200 million company. It's patently unfair to the founders.

Furthermore, setting a note with a cap effectively communicates an implicit price for the equity--so you're actually undermining one of the key reasons for doing a note in the first place. Particularly if you set a cap high, which many founders do, you're implicitly communicating a target for your Series A.

Even though you're using a note, you're still setting a price before you have any intel on what that should actually look like. If you set the price wrong, you can easily screw over the investor or the founders.

So When Are Convertible Notes Worth It?

In my opinion, there's only one time that founders should really be using convertible notes--tiny investments for essentially pre-seed rounds. Really, I'm talking about friends and family money here.

Convertible notes can be useful if you're just trying to drum up some small cash quick to cover initial operating expenses. If you're raising on the order of $10,000-20,000 at the very beginning of starting your company, convertible notes can be an effective way to do that. But even so, you need to be careful, and you should draw up supplemental documentation to give both the founders and the investor some protections from the pitfalls of convertible notes.

If you don't, it's very easy for either side to end up getting screwed and create huge problems down the road. As an early-stage founder it may be tempting to give away equity for money now, but if you really believe in your product, that should not be an attractive option.

Nothing hurts more than giving away the fruits of your blood, sweat, and tears for a song--no matter how sweet it may sound in the moment.

Published on: Aug 25, 2017