As a founder, I’ve raised money for startups a couple times over the last few years. I’m also an experienced business lawyer, so I see early stage financings from two sides of the equation.
This post is about convertible note financings in very early stage Internet companies. There are plenty of resources online explaining the basics of equity vs. convertible note transactions, so I’m not going to speak to those basic points.
Instead, I want to offer some guidance around a scenario that is covered less often. Before you get to the sophisticated angel investor crowd or to venture capitalists, many startups will raise some level of “friends & family” money. It’s very likely that these investors have never invested in a startup company before. They have no context for the norms and market terms of early stage investing.
In these scenarios, financing the deal with a convertible note instrument is very often the right move. It’s faster, it’s cheaper and it avoids a valuation decision that these investors are truly not qualified to make.
But here’s the problem. I’ve never met an investor from outside of the Internet startup scene who is comfortable with the concept of a convertible note when it is first explained to them. It’s not that they necessarily view the convertible note as less favorable to their interests. Instead, they simply do not understand how the note works or what they are ultimately buying. This discomfort leads to friction in the fundraising process. Friction is bad.
The startup blogs don’t deal with these issues too often because the blogs are written by investors from within the startup investing world or by entrepreneurs raising money from those sophisticated startup investors. These bloggers have a clearer sense of market norms and they understand how later stage financings play out. Our friends & family investors do not.
In this series of blog posts, I’m going to explore a number of common issues that I’ve seen friends and family investors raise in regards to convertible note instruments.
At the end of the day, investors want to understand what they are buying for their money. Unfortunately, the true answer is that “it depends.” But with a good model, you can test likely scenarios and provide some comforting guidance. As part of this series, I’m going to open-source a complex excel model that I’ve spent a lot of time developing. I’m hoping that input from readers can help develop this model into a fairly comprehensive resource.
I’m looking forward to thinking through these issues and making this as helpful as possible. If you have any questions, I’d love to hear from you in the comments.
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Legal: Nothing contained herein should be construed as legal advice. If you’re raising money, you should contact a lawyer.
