Why Convertible Notes Are Not Great For Investors

A couple weeks ago I wrote a post explaining how many startups are playing dangerous games, banking on small convertible note seed rounds to bridge the gap until they can raise their valuation and then close a Series A without giving up as much of the company.

A VC friend recently shared an additional insight that he finds troubling with these types of convertible note deals. It seems that several VC firms have “loanedâ€� $250-$400,000 for which they have given the receiving startup little to no additional support. Of course the same level of human capital investment can’t be expected from venture firms investing such small monetary amounts, but still, the idea in taking smart money is receiving smart money benefits.

It also seems that some VCs use this “interimâ€� period as a chance to evaluate whether the seeded company is really taking off. The expectation of convertible note deals is that there will be a follow on Series A relatively quickly with the seeding venture firm leading the round (they usually have preferential right to lead). During the interim period, venture firms focus on the adoption rates and conversions achieved by the startup. If those milestones are not being hit, apparently some VCs are passing on leading the Series A. Instead these VCs favor throwing in the towel and dispersing more ‘small investments’ until they find a ‘really hot company’ they want to do a Series A with.

This practice, if true, leaves decent to mediocre startups in the lurch. Especially because $250,000 only buys you a little bit of time, it can be a painful reality check when adoption is not going amazingly well after only 5 months. Not only that, but when the VC firm that seeded a startup refuses to then lead the Series A, it sends a seriously negative message to other potential investors. Forced to look for new sources of capital a startup in this position will likely take a major haircut on equity, or will be outright denied additional capital.

Thus, a serious question to ask yourself as an entrepreneur is: how much does your VC or Angel really have invested in you? When the going gets tough, will they be still be there? Or, is it possible they will walk away hunting for a better opportunity?

Thus, while a convertible note deals sound hugely appealing, smart entrepeneurs should check-in with other active portfolio companies seeded by the potential investor; good due dilligence pays dividends.

Update: Brad Feld on why he doesn’t like convertible note deals

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