1.As a general rule, founders like notes and investors do not. The reason notes are more often used today than before is one of power and control. Founders today have more bargaining power and can insist on going with notes. Investors may not like this but, if they like a company and want to invest, that is their option. This reflects a longer-term trend by which quality startups have become easier to launch with comparatively smaller capital needs, and this has enabled founders to keep more control through the early stages of a company's growth. I believe this trend is becoming permanent, which is one of the reasons for pg's observations about the predominance of notes in today's climate.
2. Building a startup is a teaming effort and the ideal cases consist of founders and investors who work together to build a great company while keeping their interests aligned. But this point only goes so far. Just ask any desperate founder who is under a cash crunch how much investors are prepared to give their cash on founder-friendly terms in the name of "alignment of interests." At a basic level, the issue with funding centers about power and control. Founders use notes because they can, and investors allow it because they have no choice if they want to invest.
3. The main advantage with notes is that they come with few strings. Once you set up preferred stock, investors become a dominant (even if not controlling) force within the company. Many things that you once had freedom to do you are no longer free to do without investor consent, and that includes choices about future funding. In addition, with notes, you don't have to reprice your stock price or fool with such things as 409A valuations too early in the company's history. With equity, you inject added costs and complications, and many founders want to avoid that in the very early stages. Such things tend to be distracting and tend to put more emphasis on fund raising as a process than would otherwise be the case. Again, just ask the YC companies who are getting the $150K notes with almost no strings attached. The main benefit: it lets them concentrate up front more on building their products than if they had to hustle up survival money right up front.
Bottom line: most founders will go with notes when they can because of power and control and intangible factors such as alignment of interests with investors, the educational value of learning to manage a board, etc. will not normally sway them in the other direction.
All that said, this is a a splendid dissection of some of the key factors affecting the use of convertible notes in early-stage funding. A very nice piece.
An ordered reply. I personally do not care note versus not, but am friendly with many angels who do and think they have great points.
1. Notes are worse for founders in most cases. Manu outlines why quite well. Misalignment, downside protection only for investors w/ a cap, liquidation preference, callable debt that can kill companies.
2. Many of the best seed investors do not do notes anymore, so they're not really allowing it. Founders appear to be using notes because of the opinions of a few people, mostly investors themselves. The same bias should apply there.
3. I agree here, but then someone should come up with standard docs with no strings (kinda like YC's Series AA docs). It will be a bit pricier but not much. See Fred Wilson's post today.
Most founders go with notes because someone they trust has told them to not because they have thought it out. And that's fine, but especially lately I continue to hear more stories where founders have gotten screwed by notes.
In particular I recently heard about an Angel calling in their debt and killing a Series A. That doesn't seem like what's best for the founders.
1.As a general rule, founders like notes and investors do not. The reason notes are more often used today than before is one of power and control. Founders today have more bargaining power and can insist on going with notes. Investors may not like this but, if they like a company and want to invest, that is their option. This reflects a longer-term trend by which quality startups have become easier to launch with comparatively smaller capital needs, and this has enabled founders to keep more control through the early stages of a company's growth. I believe this trend is becoming permanent, which is one of the reasons for pg's observations about the predominance of notes in today's climate.
2. Building a startup is a teaming effort and the ideal cases consist of founders and investors who work together to build a great company while keeping their interests aligned. But this point only goes so far. Just ask any desperate founder who is under a cash crunch how much investors are prepared to give their cash on founder-friendly terms in the name of "alignment of interests." At a basic level, the issue with funding centers about power and control. Founders use notes because they can, and investors allow it because they have no choice if they want to invest.
3. The main advantage with notes is that they come with few strings. Once you set up preferred stock, investors become a dominant (even if not controlling) force within the company. Many things that you once had freedom to do you are no longer free to do without investor consent, and that includes choices about future funding. In addition, with notes, you don't have to reprice your stock price or fool with such things as 409A valuations too early in the company's history. With equity, you inject added costs and complications, and many founders want to avoid that in the very early stages. Such things tend to be distracting and tend to put more emphasis on fund raising as a process than would otherwise be the case. Again, just ask the YC companies who are getting the $150K notes with almost no strings attached. The main benefit: it lets them concentrate up front more on building their products than if they had to hustle up survival money right up front.
Bottom line: most founders will go with notes when they can because of power and control and intangible factors such as alignment of interests with investors, the educational value of learning to manage a board, etc. will not normally sway them in the other direction.
All that said, this is a a splendid dissection of some of the key factors affecting the use of convertible notes in early-stage funding. A very nice piece.