No, Notes, No

Lots of good discussion on the interwebs this week about yet another problem with Convertible Notes as an early stage financing tool. See Mark Suster’s and Brad Feld’s posts. When I financed Wallaby’s seed round I used a note. I would not use a note again. Let’s look at some myths vs. reality.

Myth: Notes are easier to close.

Reality: Closing any investment requires successfully convincing an investor to provide you capital for a business. The form of financing doesn’t make a big difference here. If people are in, they are generally in. Especially for seed and pre-seed rounds, when convertible notes are used, the financing type is not the main point. Additionally, there is a small subset of investors who will NOT use notes, so that actually makes it harder.

Myth: Notes don’t need a lead, you are the lead.

Reality: Sure, the company “sets” the terms of the note. I use obnoxious quotation marks here because in reality you need a lead investor to agree to those terms. There is a still a term sheet for a note. Everyone who buys in has to agree. The only real difference here is the expectation that the startup provides the first negotiation point, which you may do in an equity round anyway.

Myth: Notes are simpler and cheaper.

Reality: As the aforementioned blog posts point out, there are just as complicated issues with writing good convertible note docs as equity. In fact, with the advent of Series Seed docs. With Series Seed you get a crowd-reviewed, standardized set of terms that still provide equity. Many startup investors are used to Series Seed and it is the one option with little negotiating. In my experience attorneys can and will find a way to charge standard fees, so your mileage may vary but a note is not substantially cheaper than equity for fees.

Other concerns, I want to point about notes:

1. Notes are legally debt. As a result your company is net negative from the moment you start spending your raised capital. This will negatively impact your business insurance rates and potentially your deal flow, as procurement departments at big customers won’t like it.
2. Notes accrue interest over time. If you use your note for a long time (I know you don’t plan to, but shit happens), the investors keep earning interest which eventually eats more of your equity at a conversion event.
3. Notes expire. (Again, I know you plan to have raised a Series A by then.)  At Wallaby, we had to extend our note expiration twice. This involved spending time and money on having lawyers write an amendment, and collecting signatures. Just when you need one, your VC lead will be traveling to Nigeria or something. It’s not easy or cheap.
4. Notes are confusing. Except for very experienced investors and startup operators, they are just less well understood than equity. If you get asked what your share in the company is you won’t know. You’ll have to look it up every day as you accrue interest.

Notes have a reputation as founder-friendly. I found nothing friendly about notes. I won’t use them next time.