While I haven’t seen authoritative numbers around convertible note usage for seed rounds, I can confidently say that the overwhelming majority of seed deals completed in Silicon Valley are done through convertible notes.
In fact, while I get a ton of questions daily from entrepreneurs about the nuances of seed financing, the questions rarely stem around whether they should raise through a priced round or a convertible note. The latter is usually a foregone conclusion – not because of any particular financial or strategic rationale, but rather a byproduct of conventional “wisdom”. Wisdom that has come under some fire from investors.
While I do think that priced rounds are much better in general than notes, I’m not here to take a hard line against notes (as in certain cases, they could make good financial sense). Instead, I just want remind entrepreneurs to consider the facts before defaulting to a note option.
A few summary points to consider:
1/If you set a cap, you are setting a valuation. It’s the figure that your current and next round investors will anchor around.
2/If you don’t set a cap, you’re screwing your convertible note investors and probably yourself. I can’t imagine any smart, value-add investor today investing in a no cap note that doesn’t contain any protections.
3/Things can get messy at conversion if you do multiple notes or have notes that have multiple caps.
4/Priced equity rounds are cheaper and faster than ever to do (which was the primary argument for notes).
5/You can do rolling closes with equity rounds.
6/While it’s true that notes don’t absolutely require a lead, that’s a not a good thing. A bunch of lottery ticket investors isn’t what you want as it’s much better to have 1-2 investors that have true conviction and have financial incentive to help.
7/Many institutional investors won’t participate in anything but a priced round.
8/While you do get to “punt” some of the term negotiation to later, I don’t know why that’s necessarily a good thing.
Now back to my earlier point about notes making sense in certain situations. One example is if there is a defined short fuse to the next round of capital (3-4 months), and you just need a bit of liquidity to get there. An uncapped note with a discount is the best form of financing here.
Regardless, if you opt for a note for a standard seed deal, here are few recommendations:
Be thoughtful about the cap you set if you have a capped note. Check out whatever data is available. Talk to other entrepreneurs and investors. But never set it based on edge cases – I.e. “I think the cap should be “$X” because ABC company just got a Series A at a $50MM pre-money”. All that will do is add more risk to the already very risky thing you are doing. Also, include a discount as well. It doesn’t seem equitable for early investors to convert at the same valuation as next round investors despite putting in capital 12-18 months prior (if the next round pre-money is done exactly at the cap amount).
Try to limit the number of notes you do to no more than a couple (although one is better).
If you don’t want to set up cap, create a structure that protects early round investors. One example could be a sliding discount scale whereby the size of the discount increases with certain valuation hurdles. Haven’t seen this much, as it could create value manipulation in the next round, but it’s better than a straight uncapped note which will lead you down the path of getting only unsophisticated, unhelpful investors.
For full disclosure as an angel investor, I’ll participate in convertible notes fairly regularly as it’s remains the buy-in reality for many opportunities.