Why Entrepreneurs Should Avoid Convertible Notes, and Other Wisdom Gleaned From Raising $1M From Silicon Valley Angels
Daniel Odio4/11/11
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cost differentials between a priced round and a convertible note. (Notes have traditionally been viewed as faster and cheaper financing instruments because they’re not as complex, but having quality seed documents available for free negates this advantage.) Additionally, if thinking like an investor, I’d be more personally invested in a startup where my capital is put to work in exchange for a piece of the company.
We’ve been lucky in the sense that a good chunk of our angel investors have been very supportive and active in promoting our success. In one instance, though, the note uncovered a misalignment of interests between our company and the note holders. We wanted to raise an accounts receivable line of credit for our business, and the bank wanted to subordinate all of the existing debt below the A/R line (something that’s a very common practice, as outstanding A/R is considered to be strong collateral to collect against. Banks provide low interest rates on A/R lines on the assumption that should something go wrong, they can collect on A/R before the other creditors get paid and get out without too much exposure). However, our $1 million note holders were very vocal that their convertible note was not to be subordinated, and I completely see their perspective. They were the first ones to believe in us-they did not want anyone usurping their primary debt position, no matter what the reason.
One of our note holders helped me broker a deal that allowed for the A/R line to go through, but the potential for a conflict of interest became very apparent to me based on this scenario, and I’m sure it was also distasteful to the note holders. This problem would’ve been completely avoided had we done a priced equity seed round. If you’re looking to raise your first round of angel financing, I’d recommend you look past the convertible note. It may feel easier now, but the potential for conflict will be there later, and you don’t want anything distracting you from growing a successful business.
In the end, what matters the most is the entrepreneur’s unwavering commitment to creating something from nothing. My hat is off to other entrepreneurs heading down this path, and I hope our experience can enrich yours.
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