Convertible Note vs. Priced Preferred Round
The form of an investment is an on-going issue for Angel Investors and Startup entrepreneurs. This post describes the differences between a convertible note and a priced round, the benefits of each, and recommendations for investors, service providers, and entrepreneurs.
A priced round is easy to understand. Each investor in that round is told the price per share, and is issued shares (generally preferred) at that price. Legal fees for a priced round are usually in the range of $25,000 to $50,000. So for a small round, the legal fees can be a significant portion of the round. Also, many entrepreneurs and investors cannot agree on the valuation of the company to set the price. I believe that this is the wrong reason to avoid a priced round, because it is indicative of a deeper problem and fundamental disagreement between the investor and the company. Would you buy a car, where you didnt know the price till you had driven it a year?
Many lawyers recommend that startups offer investors a convertible note, a form of loan that converts to equity when the next round is closed, usually with some form of discount. It is both quicker and incurs lower legal fees than a priced round. In general, these notes are used to bridge a company between two funding events, e.g. between a friend/family round and an institutional round. There are several key parameters in these notes. They are outlined below (with what I consider average values in Seattle today):
1) What is the term of the note? This can range from 3 months to 18 months. In general, most of the deals I see have a term between 6-12 months, where 6 is more investor friendly and 12 is more entrepreneur friendly.
2) What is the discount? This discount can take two forms. One is a plain discount, where the investor gets a price per share that is less than the next investors. The second, is the issue of warrants, where the investor gets warrants issued as a discount (e.g. 1 warrant for every 4 shares = 25% discount). This is to some degree related to the term the longer the term, the higher the discount. It is rather common for the discount to increase with the term (e.g. 20% for the first 6 months, then increasing by 5% per month for the next three months). Currently, the discount is about 20-30%.
3) What is the interest on the note? In general this is either prime plus some percent or a fixed percent. Lately, I have seen 8% annual.
4) Is there an assumed value? This takes two flavors in the docs. First is what happens if the company doesnt raise its round before the term of the note. For example, if the company issued a 6 month note, but didnt raise its round, at what price does the note convert? Usually, investors will insist on a price that is prevailing for the company at the time the note was issued. This is often the last round pricing. For Seattle startups, without a final product or customers, that is typically in the $1.5M to 2.5M range, but there is great variability depending on lots of factors. The second flavor of the value is what will happen if the company is acquired before raising the round. For example, if the company takes in a convertible note for $1M, but then sells for $100M before the conversion? Unless otherwise specified, the investor only gets their principal plus interest (in this case $1M plus 8%), while entrepreneur gets the other $99M. As an investor, I like to be aligned with the entrepreneur, so would set an assumed value in this case, so that the investor has their choice of either the principal plus interest OR conversion at a fixed value (say $5M) in this case.
5) Does the investor get any say in the terms of the round? When the company raises their round, it might be at terms that the investor would never have agreed to, but rarely has the right to do anything about it.
So, in conclusion, investors like priced rounds, and usually fight for them. Entrepreneurs often benefit from convertible notes. If the note is short term and has reasonable terms, its not a bad idea. However, there has been a trend for longer notes (more than 6 months), at a time when the next financing round is not pending. In essence, this is the company asking the investor to put up their money to build value in the company so that they will then pay a much higher price per share. As an investor, not something Im inclined to do.