Good read from Fred on convertibles

Not cars but notes :: http://avc.com/2017/03/convertible-and-safe-notes/

His reasons about why not to do are so good.

2. They obfuscate the amount of dilution the founder(s) is taking. I think many investors actually like this. I do not. I believe a founding team should know exactly how much of the company they own at every second of the journey. Notes hide this from them, particularly the less sophisticated founders.

This one is good. Many times I find even that the founders don’t know what they are talking about and have not figured out their own dilution. They also may not have carved out something for the ESOP and are not taking that into consideration as well.

3. They can build up, like a house of cards, on top of each other and then come crashing down on the founder(s) at some point when a priced round actually happens. This is the worst thing about notes and doing more than one is almost always a problem in the making.

This is the one we see too many times. Rolling notes or extended notes that take a serious Excel expert to figure out how each round is actually priced and who owns what. You have to be careful about this so that you know what each round is doing and how to calculate the dilution.

4. They put the founder in the difficult position of promising an amount of ownership to an angel/seed investor that they cannot actually deliver down the round when the notes convert. I cannot tell you how many angry pissed off angel investors I have had to talk off the ledge when we are leading a priced round and they see the cap table and they own a LOT less than they thought they did. And they blame the founder(s) or us for it and it is honestly not anyone’s fault other than the harebrained structure (notes) they used to finance their company.

Yup. Also, see this. They over promised angels with too high a valuation cap and once you see a few rounds of this by the time you actually calculate it all one will find the dilution and ownership.

The list of stuff he says to do is gold. Freaking gold:

Here are some suggestions for the entire angel/seed sector (founders, angel investors, seed investors, lawyers):

1. Do priced equity rounds instead of notes. As I wrote seven years ago, the cost of doing a simple seed equity deal has come way down. It can easily be done for less than $5k in a few days and we do that quite often.

2. The first convertible or SAFE note issued in a company should have a cap on the total amount of notes than can be issued. A number like $1mm or max $2mm sounds right to me.

3. Don’t do multiple rounds of notes with multiple caps. It always ends badly for everyone, including the founder.

4. Founders should insist that their lawyers publish, to them and the angel/seed investors, a “pro-forma” cap table at the closing of the note that shows how much of the company each of them would own if the note converted immediately at different prices. This “pro-forma” cap table should be updated each and every time another note is isssued. Most importantly, we cannot and should not continue to allow founders to issue notes to investors and not understand how much dilution they are taking on each time they do it. This is WRONG.

Again. One can do notes. They serve a purpose but I think most founders don’t know what they are doing with them and assume that it is better than equity but in fact dealing with a proper equity round might make more sense. Normally the reason to do a note is speed and you expect that pricing the round later makes more sense than pricing it now. Regardless one shouldn’t do many rounds as notes, leave notes open for too long and delay the hard work of pricing and converting.

Obviously, I am new at this but Fred isn’t!