A Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes

http://www.bothsidesofthetable.com/2015/05/30/one-simple-paragraph-every-entrepreneur-should-add-to-their-convertible-notes/

by seehafer • 11 years ago

56 10 11 years ago

bothsidesofthetable.com

gumby4• 11 years ago

(just commented on his blog but since I found this on HJ):

Why have a cap at all? It doesn't help the company, and is often used as a proxy for valuation, which it isn't (and is bad for the company). I don't think it's that great for the note holder either, who gets the discount regardless.

The use of a cap is quite a recent phenomenon (and I wrote a bunch of $500K notes without caps just a few months ago) -- so let's get rid of them.

diziet2• 11 years ago

Because it 'protects' against a company raising say 1m on notes, and growing to a 30m valuation series A. You also get the debt preference in case of acquihires and early exits.

For institutional investors, all they now only make the discount return on the note, while for an angel, well all you get is to participate at the series A.

Bad for the company, great for investors.

gumby4• 11 years ago

Because it 'protects' against a company raising say 1m on notes, and growing to a 30m valuation series A. You also get the debt preference in case of acquihires and early exits.

Good point about the acquihires, which is a case I hadn't thought of. But for anyone building a real business I only see it as a disadvantage.

Consider three scenarios:

1> angels get equity (series "pre-A"). Set a price. Now the next round values the company at 30M pre -- they get a small chunk of a company worth a lot, and that has a good chance of being worth a lot more in future.

2> Angels don't set a price: Now the next round values the company at 30M pre -- they get a 20% larger chunk of a company worth a lot, and that has a good chance of being worth a lot more in future.

3> Angels put a cap which has now become a de facto price, say 10M. Now the next round values the company possibly at 30M pre -- but especially due to the "anchoring" effect of having a number out there it's maybe 20 pre. They get perhaps more of a smaller company, and the founders get diluted more (since the new investor still wants their percentage -- the growth comes out of the founders' hide.

This creates a conflict of alignment between the note holders and the founders.

These caps are typically unheard of on bridges and other debt instruments companies take on later (except for dying companies) because the preferred shareholders know full well how destructive they are. So why subject the founders to these terms. Because they are naïve and you know you can get away with it?

For institutional investors, all they now only make the discount return on the note, while for an angel, well all you get is to participate at the series A.

All kinds of entities get the same terms on the note. Both get the discount.

Bad for the company, great for investors.

Yes, that's precisely how I see the cap.

abalone• 11 years ago

Caps are definitely advantageous for the note holder. The increase the discount if the cap is exceeded.

If you're an investor willing to do a bunch of $500K no-cap deals I know a lot of founders who'd like your phone number.

gumby4• 11 years ago

If you're an investor willing to do a bunch of $500K no-cap deals I know a lot of founders who'd like your phone number.

I'll bet, but it was the other way around: a bunch of investors bought uncapped notes.

I just find the caps make it complex to do the next (in this case first) equity round. And I want my cap chart to be as vanilla as possible.

rahimnathwani2• 11 years ago

The reason to use a convertible note is because the parties can't agree on a valuation at which to issue equity. They _can_ agree that the angel should get at least x% of the company, and from this they can calculate the valuation cap.

A note issued without a cap limits the upside of the angel in exactly the situations when his/her investment has helped the company increase its valuation the most.

Anyway, this post isn't about that. It's about ensuring that liquidation preferences are limited to 1x, which seems reasonable, especially if the note has a coupon.

gumby4• 11 years ago

Anyway, this post isn't about that. It's about ensuring that liquidation preferences are limited to 1x, which seems reasonable, especially if the note has a coupon.

My point is that the cap is mathematically equivalent to a liq pref, but worse, it's one that is applied up front (before a liquidation event, so its a conversion pref).

nscheffey• 11 years ago

One simple CSS rule this blog should add to its stylesheet:

  h1.title {
    padding: 20px;
  }

A Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes

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