editione1.1.4
Updated September 15, 2023You’re reading an excerpt of The Holloway Guide to Raising Venture Capital, a book by Andy Sparks and over 55 other contributors. A current and comprehensive resource for entrepreneurs, with technical detail, practical knowledge, real-world scenarios, and pitfalls to avoid. Purchase the book to support the author and the ad-free Holloway reading experience. You get instant digital access, over 770 links and references, commentary and future updates, and a high-quality PDF download.
In a priced round, investors purchase newly issued stock in a company at an agreed-upon price per share. A priced round is more a type of financing structure than a type of round, though it can be helpful to refer to raising a priced round as different from having raised through other types of financing structures.
A founder may say, “We raised a priced round,” meaning they sold equity in their company in exchange for investment. Alternatively, a founder may raise on a convertible instrument, of which there are two types: convertible notes and convertible equity.
Convertible instruments are used frequently in early-stage venture capital deals. While priced rounds are still the preferred mode of investment by venture capital firms, they don’t always make sense when companies are at the pre-seed or seed stages. That’s because priced rounds are most beneficial when investors and founders—buyers and sellers—can agree on the value of the company.
Definition A convertible note (or convertible debt) is a short-term loan that is designed to be repaid, plus interest if applicable, with equity in a company. A subsequent financing round or liquidity event triggers conversion, typically into preferred stock. Convertible notes may include two options for determining the number of shares for which they will be exchanged: a discount and a valuation cap, which incentivize early investors to take risks on unproven companies. If a convertible note is not repaid with equity by the time the loan is due, it must be repaid in cash like a normal loan.
Convertible notes generally specify that the subsequent financing round must raise at least a specified amount of capital for conversion to occur. Typical thresholds for a qualifying financing round are in the $1–2 million range.*
Definition Convertible equity is a financing structure that mimics convertible notes but is not technically debt and so has no interest rate or provision for repayment in cash.* Like a convertible note, convertible equity is designed to be exchanged for shares in the company at the time of a subsequent financing round or liquidity event. Convertible equity also may include a discount or valuation cap to incentivize early investors to take risks on unproven companies. The most common form of convertible equity for seed investments is Y Combinator’s safe.*
Convertible notes, originally created for use in bridge rounds, were later adapted for use in angel and seed rounds, and were popularized in the late 2000s by Paul Graham of Y Combinator. Prior to Graham’s introduction of the safe,* notes were the preferred financing structure for early stage deals. While safes are the most common structure in Silicon Valley and more mature ecosystems like New York City, convertible notes are still widely used elsewhere in the United States.
important Notes are a popular financing structure for early-stage investments in startups but are viewed differently by investors in different parts of the U.S. In Silicon Valley, many investors and founders understand that a note is technically a loan, but don’t treat it as such. The emphasis on a note being a loan is often made by investors in other geographies and is used to justify higher interest rates and stricter terms on repayment. Founders should know that this goes against the intent of convertible notes, at least as they are used in Silicon Valley.
Many of the challenges for founders associated with notes have been addressed by the creation of convertible equity. There are a lot of strong opinions out there on which financing structure is best for founders, but the truth is, there are benefits and drawbacks to each option, and each option comes with its own risks.
controversy Many founders will at some point come across an advisor (another founder, a VC, et cetera) who takes the position of, “Look, your company is either going to be huge or dead. And if your company is huge you won’t care if you own 1% or 20%, so stop worrying about valuation and dilution so much. Just get the financing done and move on.” Honestly, there is a bit of truth in this, but it leaves out all the middle (and much more common) scenarios where the company sells for some amount in the low to mid-millions. There are definitely experts on both sides of this issue, and the reason this advice is dangerous is that it encourages founders to not understand their decision down to the bones.
We’ll discuss the key aspects of convertible instruments shortly, like the valuation cap and discount, which are crucial to understand if you want to avoid some serious hurt. But when deciding which financing structure is right for the round you’re raising now, there are a few points you can start with: amount, stage, certainty, flexibility, legal fees, and control.
As a simple rule, most seed rounds under $1M are done on either convertible notes or convertible equity deals like safes. While it’s not entirely uncommon in Silicon Valley for rounds up to $3M or $4M to be done on convertible notes or safes, the greater a deal gets in size after $1M, the more likely it is that the deal will be done on a priced round.
Priced rounds are seen as advantageous to investors because they know exactly what the price of the equity they’re buying is at the moment of the transaction. At the earliest stages, however, many startups raising venture capital will choose to utilize a convertible instrument—like convertible debt or convertible equity—because it is nearly impossible to predict how valuable their company will be 12–24 months from the date of the transaction.
When a company is little more than two people with an idea, it’s hard to tell whether that team of two will build a company with $1M in revenue in 24 months or go bankrupt. On the other hand, when a company has been operating for a few years, is generating revenue at a steady growth rate, and investors can compare their metrics to larger companies in the same market, it’s much easier to propose a price and valuation both sides can agree to.
Convertible instruments present uncertainties to investors that priced rounds generally do not. In a priced round, an investor knows exactly how much of a company they will own after investing. Convertible instruments defer a negotiation on price, and therefore ownership, to a subsequent round of financing past a threshold set in the term sheet. Cap and discount mechanisms in convertible instruments can be used as proxies for price in that they set a maximum price for investors at conversion. For example, if a company raises $1M on a convertible instrument with a $6M pre-money cap, the investors are not agreeing that the company is presently worth $6M, but rather saying they believe the company will be worth at least $6M by the time the company raises another round of financing.
Caps on convertible instruments can lower the risk to a palatable point for early-stage investors. We’ll explain this in detail later, but the way this works is, if—using the same example—the company raises its next round of $4M on $12M pre-money, the early stage investors will pay much less per share for their stock than the new investors, because of the cap. Founders should be cautious, however, as an investor can end up getting an absurdly good deal—and founders’ ownership will get heavily diluted—if they invest on a low cap and the company ends up raising the next round on a valuation significantly higher than the cap.
Because of the uncertainty around how much a business is worth and how much a risk an investment is, early-stage companies struggle to find a lead investor to set a price in a priced round. The major benefits of both convertible debt and convertible equity is that these approaches allow you to raise smaller amounts of money from more investors, you don’t need someone to act as lead investor, and you can adjust your terms as the fundraising process evolves.
important One of the attractive elements of convertible instruments is how they recognize the highly dynamic nature of value creation in an early-stage company. In a priced round, founders must know how much money they need to raise, and sell equity in exchange for that money at a fixed price they deem favorable. Convertible instruments allow for a more dynamic style of fundraising, which Paul Graham coined as “high resolution fundraising.”
With this method, a company can raise a smaller amount of capital at one price when the company is small, and more capital at a higher price as the company garners more investor attention. This is possible with the low cost, and speed, associated with convertible notes.
When a company is just getting started, they may not be able to predict how much money they’ll need to operate and reach milestones for 24 months. Additionally, the value of an early-stage company can drastically change month-to-month. For example, one month a company may just be two founders, and six months later they may have four employees, ten customers, and $100K in revenue. When they’re two people, they can raise a little bit of capital at one price, and more at a higher price when they’re six.
Raising money is expensive. Priced rounds require complicated paperwork to align founder and investor expectations, particularly around who gets paid how in the event of an exit, and to make the terms of the investment legally enforceable. Often, the legal paperwork supporting a priced round can range from $50K–$100K, and in rare cases even more.
When the total round size is below $1M—or even slightly above it—it seems silly (and possibly insane) to spend 5–10% of the overall investment on the legal fees a priced round requires. Because of the flexibility allowed with convertible instruments, it’s easier to execute the necessary legal documents with investors, so you won’t spend as much on legal work as is required when you raise a priced round.
One of the main draws of convertible instruments is that they involve less paperwork and lower legal fees than equity financing. A Series A can cost $50K or much more in legal fees. With convertible notes, you can spend as little as a few thousand dollars to secure a loan that later converts into equity.*
caution But, as with everything else in the convertible universe, there is a catch. In some cases, investors will require you to cover their legal expenses as well, just as they can do with a priced round. Moreover, convertible instruments that convert to preferred stock entail more complicated paperwork than notes that don’t, and more complicated paperwork means more money paid to lawyers.*
Many investors and founders raising money through convertible instruments use templates often referred to as “standard docs.” Standardized template documents, like the open source Series Seed documents, make it possible to raise a seed round for $1,500–$2K in legal fees, because they cut down on the time needed to negotiate a large set of terms.*
caution But just because someone tells you the paperwork is on “standard docs” doesn’t mean the terms in that template will all be in your favor. Be sure to pay attention and have a lawyer involved in the negotiation so you don’t agree to something against your interest.
No matter what financing structure you raise with, legal fees are negotiated as part of the term sheet.
The differing legal fees between these models are related to how quickly deals under different financing structures can get done. In theory, convertible equity allows founders to fundraise faster than with traditional equity financing, by eliminating the need to negotiate the terms of direct equity investments up front. Template documents for convertible equity, like the safe, also speed along the process significantly. While this argument sounds good on paper, it’s worth noting that convertible equity doesn’t remove the need for a negotiation entirely, as investors who agree to convertible equity may still have to agree whether the convertible equity will be capped or uncapped.
Priced rounds (equity financings) are not debt like convertible notes are. While founders may give up some control of their company via protective provisions and board seats in an equity financing, investors will not have the right to force a company into bankruptcy by choosing to collect on the debt.
danger Convertible notes are often heralded by investors and founders alike as one of the cheapest, fastest ways for a young company to raise money. Unfortunately, very few founders understand how much control debt of any kind gives the lender. Let’s be clear: there is nothing more powerful than being the holder of a company’s debt when that debt has matured and is due.
This means that if a company does not have the money to repay the holder of a convertible note—which is debt!—when it has matured, the investor can force the company into bankruptcy.
How could this work in practice? Imagine this scenario: A company raised $500K on a convertible note with a one-year maturity date. A year later, that company is almost out of money and goes to the investor who invested the $500K on a convertible note and asks for $500K more. The investor turns around and tells the company they’ll either invest $500K for 50% of the company in a priced round or call in the debt, which would force the company to choose between a very bad deal and death. Even crazier is that a company may have raised $1M on convertible notes, and a single $25K note holder can extort the company like this for more equity after the loan’s maturity date—even if the other holders of $975K act in the company’s interest.
important Companies can avoid this issue by inserting a term that requires the convertible debt to convert into common stock at the end of the maturity period. This will work in the company’s favor, as investors will want the stock to convert to preferred stock and will then have an incentive to extend the maturity date until the company raises another round that converts the investors stock to preferred.
The elements of convertible debt and convertible equity that we list here, including amount and interest, most favored nation clause, the valuation cap, and discount, are all terms that will come up in your term sheet if your company uses one of these financing structures. As with any financing structure, you will also negotiate legal fees as part of the term sheet.
If you choose to make a deal on a convertible note, you’ll be negotiating an interest percentage on the loan, which will accrue between the time the loan is issued by the investor and the time it converts.