Convertible notes are a form of debt that converts into equity given a certain trigger, usually a second round of financing.
Pro Does not give up control to investors
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.
Pro Variable pricing
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.
Con When Uncapped the Interests of Investors and Entrepreneurs Become Misaligned
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.
Con Convertible Notes Also Can Have Multiple Liquidation Preferences
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).
Con Full Rachet on down rounds
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.