In a typical convertible note deal investors do not gain any control over the company. There are usually no control provisions or board seats attached to a convertible note deal. This allows you to keep full control over the company at least until the next major round of financing.
Convertible notes allow you to bank cheques as they come in, instead of waiting for the entire round to be closed. Organizing investors is akin to herding cats, so being able to close the deals one at a time is very handy.
The biggest advantage to convertible notes is the ability to easily give different investors different prices. This provides two very important benefits:
Gives founders the ability to give earlier investors a lower price to kickstart the round.
Founders can give "High value" investors a lower price that takes into account the value the investor brings to the table.
When there is no cap on a convertible note the Founders want to delay the next round of financing as much as possible to maximise the valuation and thus reduce how much equity will be lost when the note converts.
However this is directly against the interests of the startups investors and may cause tension and disagreements.
The advantage of variable pricing comes at the cost of multiple liquidation preferences. Mark Suster points out the problems with convertible notes and giving multiple investors different prices:
If somebody gives you money under a convertible debt note at a $2.5m valuation and another person funds you with convertible debt at $5m valuation (high resolution financing) and your equity round finally closes at a $10 million valuation ... what technically happens?
The most straightforward way to do the deal and what most people do is to issue the first investor 4 times more shares than the ultimate equity investor to adjust for the 4x discount in price (ie if I give you 4x the shares it's the same as though you paid 25% of the price for the shares). The second investor gets 2x more shares (50% discount). So in the end they all end up with Series A stock priced at the exact same price (say, $1.5 per share) but investor 1 & 2 have more stock than investor 3.
So as your initial investor at a $2.5m they now have 4x the stock and thus 4x the liquidation preferences (since each share has liquidation preferences on it).
If a convertible note has a cap and a conversion discount it can be very painful for the entrepreneur on a subsequent down round. From Mark Suster:
A new investor in your round is saying, “I’ll agree to pay the $5m, but if you raise at $2.5m I want 100% of my stock to convert at that lower price.” So my $500k doesn’t buy 10%, it buys 20%. Voila. Just like that. Convertible notes have full ratchets.
Mark also points out that the conversion discount also applies in this scenario, so the note would actually convert at less then $2.5m.
From SeriesSeed.com:
The Series Seed Documents are only 30 pages in the aggregate so that an entrepreneur can read and understand them without devoting an inordinate amount of time and energy.
The best part is that the documents have been designed to be completely "fill in the blank" to further reduce complexity and time spent in negotiation.
The series seed documents are standardized and publicly available, so there are no hidden terms to bite either the investors or the founders.
Equity deals also increase transparency, in that they are mature and well understood. In an equity deal, Founders know exactly what price they are getting instead of potentially the lower of the two different prices with a convertible note.
Recently there has been some uncovering of the hidden downsides of convertible notes, which highlighted the problem of using documents that are not fully understood. The series seed documents are essentially a simplified version of the same equity deals that have been done for decades.
Contrary to the trend of convertible notes with variable pricing, there is actually an advantage to a single price for the deal. From Fred Wilson's blog:
"It's locked in [the price] and they are in business together and aligned. The entrepreneur can't get screwed later when the price drops on them. And the investors can't get screwed later when the price jumps on them. This is a big deal. I don't understand why folks don't understand it."
If the company is unsuccessful or unable to obtain more liquidity, the founders will not have to worry about financial debt payments
Convertible notes place a Startup in legal debt. This has three primary problems:
When the Convertible notes maturity date is reached, investors can legally demand the debt be paid back which may force the company into bankruptcy.
Being in debt can inhibit startups from gaining additional lines of credit.
In some cases (depending on jurisdiction and on length of the loan term), angel investors are technically not able to legally provide debt to Startups without being licensed lenders.
Convertible equity does not have any of these downsides.
With convertible equity there is no interest paid on the round. This saves the entrepreneur equity and simplifies future fundraising.
The lack of complex interest terms is a significant advantage over convertible notes. From Startup Company Lawyer:
Convertible debt must have interest at the applicable federal rate (AFR) published by the IRS or higher, or the IRS will deem that the lender should have received imputed interest at AFR. If convertible debt with a price cap is supposed to mimic the economics of equity, then removing interest seems logical.
In addition, when a financing occurs and the convertible debt converts, creating the spreadsheet to track interest on the notes to the penny, especially when notes have been issued on different days, ends up being a painful task — especially as the closing date of a financing may be delayed and the amount of interest increases, resulting in more shares being issued to note holders.