Why Entrepreneurs Should Avoid Convertible Notes, and Other Wisdom Gleaned From Raising $1M From Silicon Valley Angels

4/11/11

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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.

Daniel R. Odio (http://bio.DanielOdio.com) is the CEO and co-founder of PointAbout, which launched the leading do-it-yourself mobile app creation platform, AppMakr.com, in 2010. Daniel specializes in social media and mobile innovations and will speak at “Cliff Notes on Raising Your First $1 Million Through AngelList” on April 12 in McLean, VA. Details at http://go.DanielOdio.com/first1MM. Follow @

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  • http://apps.facebook.com/evilleapp Susan

    Excellent information, Daniel.

    Our team members are ex-MySpace/Fox Interactive Media employees and we are just finishing the first Facebook game (eVille) on our Extrafeet platform and a couple of months from the completion of the iPhone companion version – think Foursquare meets Mafia Wars – http://apps.facebook.com/evilleapp.

    We’ve talked to dozens of one-off investors with no luck. We are now revising our pitch and working with a “10 or more” adviser to set up meetings for potential seed funding in SFO and Seattle before the end of May.

    I’ve always felt you are pointed toward the information you need when you need it, and while reading the article I thought you were talking directly to me.

    The “over the summer” issue makes sense and at the same time is quite distressing. We are bootstrapping now to such a degree that I think cardboard will be our next food of necessity :-)

    Any chance I could get a copy of the Cliff Notes presentation?

    Thanks in advance.
    Chief Herder of Cats

  • http://www.DanielOdio.com DROdio

    Susan, absolutely, materials sent.

    Also there’s a 2 hour video on raising your first $1MM from a panel yesterday you might like at http://go.danielodio.com/first1mm

    Good luck!

  • http://www.circlebuilder.com Howard Brown

    Daniel

    Your rule of 10 is right on. I raised $3m from 23 angels to launch http://www.circlebuilder.com. 23 wrote checks from close to 250 introductions over 3 years.

    I disagree about taking straight equity for your first initial investment. In taking straight equity, you need to set a valuation. For many pre-revenue, prototype or pre-launch start-ups it is very difficult to do. The investor will want a low or the lowest valuation and the founder (s) will want a higher valuation. This puts the investor and founder out of alignment from the get go. We have successfully used convertible promissory notes and warrants to date.

    Howard Brown
    Co-founder and CEO
    CircleBuilder Software LLC

  • http://www.DanielOdio.com Daniel Odio

    Howard, thanks for the note.

    I don’t disagree with your points re: hard to value a small company.

    I’m just saying this: There’s a cost to everything. And convertible notes are held up as the “solution,” but there’s a cost to them too.

    And after going through that cost, I would try it the other way next time. Because the cost feels a bit like “easy now, 10x harder later”. Yes the note pushes the valuation issue out till later. Yes the note is faster and easier to do. BUT you end up with investors that have mis-aligned interests and aren’t as motivated. So which cost is greater? It’s not an easy ‘yes’ like so many people make it out to be.

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  • http://na Nic

    What strikes me from the infographic is how useless middlemen appear to be! Am I reading this right? What defines a middleman in your market? An d could you explain the brackets on the right of the infographic,i.e. What is ‘New School’ versus ‘Old School’? (I think we know what timewasters are)
    Thanks

  • http://www.DanielOdio.com DROdio
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