Paul Graham: Convertible notes have won... High Resolution Fundraising. September 2010 The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest. By far the biggest influence on investors' opinions of a startup is the opinion of other investors. There are very, very few who simply decide for themselves.
That tends to produce deadlocks. Convertible notes let startups beat such deadlocks by rewarding investors willing to move first with lower (effective) valuations. The reason convertible notes allow more flexibility in price is that valuation caps aren't actual valuations, and notes are cheap and easy to do.
That cap need not simply rise monotonically. Different terms for different investors is clearly the way of the future. Deadlocks weren't the only problem with fixed-size equity rounds. Has convertible debt won? And if it has, is that a good thing? Paul Graham, founder of Y-Combinator, sent out a tweet on Friday saying: “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” It’s an interesting data point on Y-Combinator companies, but is this truly a macro trend?
Have convertible notes really won? And if so is that good for start-ups? Good for investors? I think the answer to these questions are that 1) it’s not at all clear that this trend is as definitive as Graham suggests; 2) it’s a mixed bag for entrepreneurs (more positive in the short run, potentially negative in the long term); and 3) it’s clearly not a positive trend for early-stage investors. First a quick terminology recap (skip this paragraph if you’re already familiar with convertible debt vs. preferred equity). Has Convertible Debt Won? I asked this question to a number of angel investors (all with institutional angel funds or running Y-Combinator like programs) and the results were mixed. Is Convertible Debt Preferable to Equity? Seth Levine of Foundry Group addresses this important topic this morning on his blog with a post, “Has Convertible Debt Won?” Seth was basing this on a Tweet by Paul Graham that said” “Convertible notes have won.
Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” I have to say that I didn’t take the question to mean that convertible debt had won for the entire market, but either way it’s clear that convertible debt has become an increasing trend. I’ve written about the topic of convertible debt at length before specifically about how angels & entrepreneurs should think about pricing. Convertible debt is an investment that “converts” into equity in the future usually at a discount to your next funding round price and sometimes has a “cap” (maximum price). Clearly this is is a trend and a topic that is interesting entrepreneurs. Here is my answer with some minor editing: Why would an angel agree to a convertible note with no cap?
Some Thoughts On Convertible Debt. Seth Levine has a long and thoughtful post on convertible debt vs equity. If you are an entrepreneur or active in the angel/seed sector, you should read it. He wrote it in response to Paul Graham's tweet that said: Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note. I am sure that Paul was talking about angel/seed rounds and was not suggesting that convertible debt has "won" as the preferred financing structure in the venture capital business. But since our firm does participate in select angel/seed rounds, this was interesting to me. I have been doing venture capital for 25 years now and have also done many angel investments personally along with my wife.
But I don't like convertible debt for a host of reasons. It used to be that convertible debt was a lot easier and cheaper to do legally. Fans of convertible debt argue that debt with a valuation cap is no different than a priced equity round. Converts versus equity deals cdixon.org – chris dixon's blog. There has been a debate going on the past few days over whether seed deals should be funded using equity or convertible notes (converts). Paul Graham kicked it off by noting that all the financings in the recent YC batch were converts. Prominent investors including Mark Suster and Seth Levine weighed in (I highly recommend reading their posts). While this debate might sound technical, at its core it is really about a difference in seed investing philosophy.
I am a proponent of convertibles, but only with a cap (I’ve written about the problems of convertibles without caps before and never invest in them). I believe that pretty much every other seed investor who advocates converts also assumes they have a cap. There are two kind of rights that investors get when they put money in company. To the extent that I know anything about seed investing, I learned it from Ron Conway. You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. False dichotomies in convertible note vs equity seed rounds. Using convertible notes vs priced equity in seed rounds is a hot topic right now.
For background, see recent posts by Seth Levine, Chris Dixon, Fred Wilson, Paul Graham, Ben Yoskovitz, Bill Burnham, Mark Suster, William Carleton and Patrick McKenzie as well as older posts by Venture Hacks, Yokum Taku, Brad Feld, and Josh Kopelman. If I missed any good ones, please let me know and I'll add them to this list. In an attempt to usefully add to this discussion (instead of repeating things from the above), I want to highlight what I think are false dichotomies between convertible notes and priced equity rounds.
FWIW, I've done four deals so far (including both types), and between each of those reviewed a ton more. Control vs no control You can do priced rounds with no control (just economic rights) and converts with some control (e.g. converts into preferred shares w/ control provisions on maturity, stipulations about early acquisitions and next financings, etc.). High-res vs non-high-res. Raising Financing: Convertible Debt vs. Equity. Seth Levine from Foundry Group touched off a debate on which is the best way to raise startup financing: convertible debt or equity. Paul Graham (intentionally or not) actually started things with a tweet, “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.” Fred Wilson joined the conversation, as did Mark Suster.
All prominent and successful investors. And generally, they’re not fans of convertible debt. But oftentimes, entrepreneurs are attracted to convertible debt, and clearly with Y Combinator, the trend is moving strongly in that direction. The two main reasons why entrepreneurs are attracted to convertible debt are: It’s supposed to be easier; and,It delays pricing the round. Pricing a round and the value of a startup is hard.
Let’s say I’m going to raise $500,000. With a convertible debenture you’ll get $500,000 (and there’s interest payments to be made too.) But there’s also the issue of a cap.