Why Entrepreneurs Should Avoid Convertible Notes, and Other Wisdom Gleaned From Raising $1M From Silicon Valley Angels
Last summer, our company AppMakr raised a $1 million angel round over 14 weeks and learned some big lessons in the process. Luckily, Brendan Baker, an MBA student at Oxford University, took an interest in our raise and documented the process, creating a visual infographic of our efforts (see below). His infographic illustrated pertinent trends in the raise period and allowed us to draw some inferences that would’ve otherwise gone unnoticed, which I’ll describe here in detail.
One of the most striking facts to emerge from Brendan’s infographic was what I call “Daniel’s Rule of 10.” It turns out that I could sniff out eager and willing angels only through connectors who made at least 10 introductions. Or to put it another way: Don’t waste your time talking to anyone who offers to make an introduction to only one angel. Focus on people who can make at least 10 solid introductions. The visual representation of this is especially striking because it’s impossible to know ahead of time who will follow through for you, so applying a rule like this could radically change the way you raise a round.
For the entrepreneur, every lead you get is golden. Follow up on every opportunity as thoroughly as possible, but keep in mind the Rule of 10. Passing on what appear to be great leads because you haven’t gotten enough introductions from the referrer may seem crazy, and I’d guess that my data set is too small to be statistically significant. But having spoken to hundreds of potential angels, and seeing as how only 8.47 percent of the angels I spoke with ended up funding us, what I can say for a fact is my Rule of 10 held true for our raise, and that’s a powerful enough inference for me to minimize my efforts on referrers who only make one intro, so I can focus on those who are willing to make at least 10 intros. Having said that, use my Rule of 10 at your own risk!
Additionally, the data showed that timing was a key component. We originally started our raise over the summer, though I heard it wasn’t an ideal time. It’s not. The season is a poor choice primarily because it’s difficult to get on the calendars of prospective investors in between their vacations. That long lead time proves incredibly distracting and has a compound effect: I was never able to be as focused as I wanted to be on the more immediate meetings because there was always a meeting with a prominent prospective investor scheduled for several weeks in the future.
As it turns out, spring is the absolute best time to go out for a raise, with fall ranking second best. The summer and the holidays are very difficult and not worth the delays and distraction. It’s better to hunker down and shoot for spring if you can control your burn, or better yet, raise the spring before you have urgent cash needs, if you can plan that far in advance.
Nailing your pitch is just as important as timing. Our pitch was still in flux in our first round of meetings, but with many of these investors, you only get one shot. We iterated quickly (as startups tend to do) and hit on some core concepts that have since become key to our business, but iterating during your pitching process is far from ideal. You want to have your pitch down cold and supplement that with supporting data and a deep understanding of the competitive landscape before you start pitching.
We ended up raising our $1 million through a convertible note (a loan that only converts into equity when you do a future raise), as many entrepreneurs are doing these days. Convertible notes have become popular due to their supposed speed and ease of execution. But I don’t recommend them, and if I were to raise our seed round again, I’d do it as a priced equity round.
Some may see this as a pretty bold statement, as convertible notes are seen as very entrepreneur-friendly. However, there is a cost to everything, and notes are no exception. It’s a bit hard for me to imagine what our world would look like had we done an equity round, but I know a few things are certain: There are open-sourced seed round legal documents that can minimize or eliminate any 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.