Lesson: Fundraising Series Seed with Jenny Lefcourt

Step #9 Convertible Notes: Convertible notes are ideal for a small amount of money and short period of time

Convertible notes are all the rage right now, and it's a way to say that people can invest and, rather than deciding what the price is, what the value of the company is today, you say it's whatever the future price round is with a discount. So, if it's going to be $100 million then you're going to get in as if it were $80 million, you know, you get this 20%. That's probably an unrealistic example, but you get the point, whether its $10 million and now it said its $8 million. And so one of the things that's in a convertible note is often a cap. In fact, uncapped notes to me are silly, and even when I was an entrepreneur, I found them silly. So a cap is saying, hey, investor, come on in. It's early. You're going to get a discount off of the next price round, and I'll make sure you're sort of covered.

So let's just say things went crazy, and my next price round really is $100 million, and you don't want to invest at that price, you're covered. It had a cap of $10 million. So I think convertible notes really serve a wonderful purpose when things are too early, too unknown, too short a period of time, that it's just not worth the legal work and the negotiation to figure out what's the price today. I personally believe that these notes have gotten abused by all sides in that they are being used to raise $2 to $3 million, they're used to fund a company for 18 months to 2 years, and they sort of have lost their purpose. So if you are raising an amount of money that will last you 18 months, I think you're better off pricing that round today and deciding what the value is. It's never a science, but pick a number that feels good to you and feels good to the investor and price that round.

And the amount of legal work, it's pretty straightforward these days. It's not a tremendous amount. The reason I like that is that people know exactly what they're investing in, exactly what they own, as do you, the entrepreneur. And when you go out for your next round, that next investor, it doesn't hurt as much because the future investor, when they give you money, they want to know, okay, the pre-money evaluation is $8 million. I'm going to give you $2 million. Your post-evaluation is $10 million. That feels good to them. While they understand the role of a note, it doesn't feel as good when you put money in and all this stuff converts along with you. And then suddenly you have an evaluation of $8 million, but all of a sudden your post is $14 million, but it's not because you raised all that money.

So I'm not sure if that makes sense, but basically, I think, psychologically, you sort of take your lumps today, price your round, and do what you're going to do. And then in the future, you sort of have a very clean, easy cap table for the next investor to come in. I am a fan of doing a convertible note if it's a small amount for a short period of time. I think that's what they were built for and that's what they're perfect for. I think that raising large amounts of money that will last you a good amount of time on a convertible note is just, to be honest, I think it's lazy and not doing the legal work today, the negotiating today, so that both parties know where they stand, you create value, and it makes it easier for the next investor to come on in. So I am not a fan of long-term, lots of money raised convertible notes.

Entrepreneurs view them differently than investors do, and it's worth having a conversation about. Because an entrepreneur will let's say, put together a quick convertible note with a cap of $10 million. In their minds, they're thinking that's their value, and they get angels in at that price. The angel investors are thinking, okay, worst case, or maybe best case, is that it will be a $10 million round. Entrepreneur is thinking I'm worth $10 million. Seed stage investors actually view that cap to be the value, because when we invest, we're not hoping on a 20% discount, we're hoping for a significant step up. So the cap and a price round evaluation, for us, are basically one in the same. That's something where I think three different parties view that same number three different ways. So you have to understand who you're talking with.

You're the entrepreneur. You have angels in who are usually not price-sensitive, and then you have seed investors in who see the world a different way. And that's simply because they expect the note as just the funding vehicle to really get an increased evaluation for the future. So a price round is just a matter of saying, what is the company worth today? Okay, it's worth $4 million. We're going to put in $1 million, which means that we own $1 million of now a company that's worth $5 million, so we own 20% of this company. It's very clear what you own versus a convertible note, it's a little bit unknown. What will the value be? Will it be above the cap, below the cap? Will the discount take effect? So you're investing in the company, but you don't exactly understand nor do you exactly own a certain amount of equity.