Some Thoughts On Convertible Debt

Seth Levine has a long and thoughtful post on convertible debt vs equity. If you are an entrepreneur or active in the angel/seed sector, you should read it. He wrote it in response to Paul Graham's tweet that said:

Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.

I am sure that Paul was talking about angel/seed rounds and was not suggesting that convertible debt has "won" as the preferred financing structure in the venture capital business. But since our firm does participate in select angel/seed rounds, this was interesting to me.

I have been doing venture capital for 25 years now and have also done many angel investments personally along with my wife. We have never done a convertible debt round. That run may soon come to an end if Paul is right. Maybe I will have to join the convertible debt parade.

But I don't like convertible debt for a host of reasons.

It used to be that convertible debt was a lot easier and cheaper to do legally. But with non-negotiated "light series A docs" from most top venture law firms out there, you can do a Series A Preferred for less than $5000. And these light Series A documents focus on economics not control and governance, just like converts do. So to me that is not a valid argument for doing convertible debt anymore.

It still is true that negotiating valuation can be very tricky in an angel round and it may be better to defer that negotiation until the next round. That is what convertible debt does. But I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes and have done that for a seed/angel round many times. So I don't think that argument applies to an investment I am making either.

Fans of convertible debt argue that debt with a valuation cap is no different than a priced equity round. That is true if the valuation cap is the same as the valuation that the investors would pay if it was equity. But if that is the case, then the entrepreneur is getting screwed. He or she is agreeing to either take the valuation that would have been offered, or something lower if the next round is lower. That is not a good deal for the entrepreneur.

In truth. there are many convertible debt deals getting done right now with very high valuation caps and some with no valuation caps. In that instance, we are simply seeing the impact of limited supply vs excess demand come into play in the angle/seed market and we need to call this what it is – a price increase.

And that is what I think Paul is actually seeing. He has done such a good job with Y Combinator and his leadership and vision has inspired a wave of seed and angel investment in web services that is unprecedented. That wave is creating price expansion. It is a seller's market and will be for some time to come. And then things will settle down. And when they do, I think we will see the angel/seed market return to a more normal place. A place where priced equity deals between entrepreneurs and sophisticated investors is the norm.

Of course, I could be wrong about all of this. It could be wishful thinking so that I don't have to eat my words and do a convert. That may well happen. Maybe very soon. Maybe my next deal. But I won't be happy about it.

#VC & Technology

Comments (Archived):

  1. DGentry

    “But I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes…”Perhaps that is possible if you’re working with a seasoned entrepreneur, who recognizes that fair deal within the five minutes alloted. For entrepreneurs with less experience, is the chance to defer that decision until after the experience during angel funding worthwhile?

    1. fredwilson

      it is not in my interest to take advantage of an inexperienced entrepreneurmy reputation is way more important than any one dealwhen someone is considering taking an investment from us, i encourage themto call anyone we have ever invested inthose calls are criticalwhat goes around comes around in life

      1. RichardF

        “what goes around comes around in life”That’s one of the natural laws of life imo

      2. JLM

        Amen — what goes arond comes around.

      3. awaldstein

        I saw Bill Clinton talk a bunch of years back on US Foreign policy under Bush. He summed up his ‘chat’ with a statement from his mother that went something like: “If you want to have friends you need to be a friend”.This was meant for the country, I took it personally and use it as a great motto to live by.

      4. Harry DeMott

        Over the years you may have written about this one topic – but it is worthy of an updated post at any rate.Just as there has been a great debate about letting named brand investors into early rounds – and the signaling effect it has on later rounds if they don’t follow on – there is also the opposite effect of having brand named investors in your company when it works well.It is essentially a leverage effect on valuation.If you are doing well and Sequoia is in there, chances are the next round will be at a far higher price than if Harry DeMott was the early investor. And the same on the flip side.What I have always thought fascinating – through all of these beauty pageants about who will invest or who should be let in – is that the coverage in the press is always about valuation and deal structure and misses the three most critical points to me in any of these deals:1. All money spends the same – it truly is fungible – so who is going to bring real help to the team on top of the money2. Who has a history of working well with companies and3. Who do you really want to sit around a table with every month (or more if necessary)If I were an founder – these issues would be far more important than price – because value creation is all about these 3 factors (as well as your own performance) and not about deal structure and pricing of the Series A round.

    1. Dan Ramsden

      Mark also wrote a fairly comprehensive overview for the WSJ about economic clouds on the horizon and their impact on VC and entrepreneurs. ( If he’s right, and if there is a seed-stage bubble (as the conclusion of Fred’s post here implies), this is happening at a very inopportune time. And entrepreneurs would do well to consider long-term consequences of funding decisions. Mark’s WSJ article is worth reading in combination with this post.

    2. fredwilson

      that link should be at the bottom of the post in the zemanta related links

  2. kagilandam

    I understand “Man (women) is a prisoner of situations and circumstances”… but why do you want to do something you know for sure ” you are not happy” about?. May be I am not the guy to tell you… you ask wise men they will most probably recommend “Drop it”.Here is an interesting note on “what bank should learn from VCs” by Paul Kedrosky … ( I liked the picture than the actual post 🙂 ).

  3. Dan Ramsden

    “seeing the impact of limited supply vs excess demand… and we need to call this what it is – a price increase”aka “bubble”… Gasp!

    1. fredwilson

      there is a big difference between valuation expansion and a bubble

      1. Dan Ramsden

        Unless something very particular has happened in the industry to fundamentally warrant the valuation expansion… unless the valuation expansion is due to reasons other than increased capital supply… then, I think, it’s a bubble. Maybe not a big one, not like 2000, but nevertheless… I think your earlier post about seed investors needing to be careful to not over-supply startups touches on this point as well. Anyway, maybe we’re just talking different semantics.

    2. John Frankel

      A bubble is something that can only be seen in hindsight. Currently, this looks like a simple supply and demand response. Note 18 months ago it was nigh impossible for startup to get funded.

      1. Dan Ramsden

        Yes, 18 month ago the pendulum was way at the opposite end, which has led to the current extreme. I think a bubble happens when fundamental value does not substantiate capital supply. You can refer to it as supply-demand imbalance, ok. Anyway, bubbles are not only seen with hindsight, but they are only confirmed with hindsight.

        1. John Frankel

          Totally agree. By the way, the best response to an irrational market, or one that you think is priced irrationally, is to sit on dry powder. I have come to understand that when things feel fine they are probably more than fine – i.e. perhaps these are NOW the good times and they might not last.

          1. Dan Ramsden

            Agreed. I sometimes mess around that, by doing nothing these days, one has a built-in capital gain, tax free!

  4. George A.

    I agree, this is a clear indicator of a seller’s market.btw, i wasn’t totally clear from your post why YOU don’t like CD debt deals (your post appeared to focus on debunking the rationale for doing them)simply put, CD deals (with strike prices that are deferred until a future valuation event) forces the investor to invest capital without knowing what he is actually buying and subjects his capital to the future mark set by new investors.That isn’t cool, not one little bit.

    1. fredwilson

      i guess i did leave that important part outequity risk demands equity returns

  5. David Bloom

    When I priced my friends and family round I considered both structures. Ultimately I went with a light A. The question I answered for my company was far would the round take us, what milestones would we hit? In my case we are capital efficient; as expected the F&F got us through several milestones including prototype, signing clients, and soon, revenue. Even with a safety margin I expected that the value of the company in later rounds would be significantly higher (knock on wood) than during the F&F round. With an expected delta of 2 or 3x in valuation even a large discount would penalize my earliest investors.

    1. fredwilson

      how has that decision worked out for you david?

      1. David Bloom

        A little early to know because we have not yet raised another round, but I feel good about where are. We hit or are on track for all the sales and product milestones, though six weeks late and with less of an operating cushion than I would like. After launch next month we will go on the fund raising circuit and will have a better view of valuation.One thing I did not appreciate sufficiently in the F&F round was how many of my investors were as concerned with tax issues as with valuation. I am not a lawyer but understand that convertible debt has tax benefits for the investor. A professional angel might not focus on this, but for friends and family, who are investing to be supportive as much as anything else, a tax benefit can be very helpful. I wonder if I had asked, whether the investors would choose a lower implied valuation from convertible debt with a tax benefit, or a better valuation from the equity.

        1. John Frankel

          Can you explain the tax benefits of convertible debt over equity? I would have thought that equity would have the tax advantage here. If it is an LLC there are losses to pass through, and if it is a C corp then QSBE can apply and the clock can start ticking.

          1. David Bloom

            John, I suspect you are far more expert on these issues than I. The issue of tax benefit was raised by my parents’ accountant and my lawyer who told me (if I remember correctly) the debt could be used to off-set income. I’ve felt somewhat guilty about this ever since, so if there is no tax benefit to debt you would let my conscience off the hook!Has your fund made convertible debt investments? Have you ever been concerned about the terms in previous debt-rounds?

          2. John Frankel

            I have no idea how debt can be used to offset income – in fact the interest on the debt may taxable even if not paid in cash. I am not a US accountant, but I am an Fellow Chartered Accountant (which I rarely admit to, by the way). Please consult with a tax expert here to settle your conscience and make you understand the issues in detail.Re my fund making convertible investments: we never do these on first investment, but are willing to do so, on occasion, in follow on investments. We have not been in a situation with previous debt rounds that concern us, though in theory if there was a huge debt round before us it might be an issue. Might we at some point invest in convertible as the first investment? Possibly, if the company was amazing, the team fantastic, the cap in place made it fair, etc. I can think of such situations, but they are rare.Bottom line here is that you want sophisticated investors and not just money, and sophisticated investors should know how to price the round. Reputation is key, and in fact the “ff” in ff Asset Management stands for founder friendly, and so squeezing a founder team on price is just a non-starter in my book, as with the other VC’s that have posted on this blog comment stream.Of course, we are all discussing the issues in terms of generalities and in fact it comes down to each specific company and the deal at the time.

  6. aweissman

    Negotiating valuation is often (always?) the most difficult part of any negotiation, particularly early stage/seed deals where the objective criteria are few. But I’ve always thought that part of running a company and part of being an investor are doing those difficult negotiations – valuation, sales, M&A, whatever. It always feels weird to me to defer that most important of negotiations – price – as part of the justification of a convertible note round.

    1. fredwilson

      great point andy

    2. bsiscovick

      seed stage valuations are completely driven by supply and demand market dynamics so I can understanding deferring price discussions when the investors involved are not professional early stage investors and are admittedly unaware of market pricing.but to your point, any time pro-investors are involved with ample market awareness there is almost no good reason to delay the pricing discussion.

  7. JLM

    Money, at the end of the day, is to the entrepreneur just —- money. The price changes whether it is equity or debt.When it is equity, valuation becomes the central issue.When it is debt, the terms become paramount; and, when it is convertible into equity it has characteristics of both.One of the aspects of convertible debt that is useful for an entrepreneur to focus on is the possibility of “re-funding” it at some future date and ransoming the convertible feature. This is an important element of the discussion.I am a fan of even handed and fair dealing and would always encourage folks to look at the balance between “put” and “call” features on a convertible debt structure.When starting a company, just get the damn money and get on with it because a few points here or there is not really important in the greater scheme of things.

    1. awaldstein

      Straight talk on money…thanks!

    2. msuster

      Actually, this is the populist view but I don’t think it’s completely correct. Sorry to disagree but for the sakes of debate / discussion / learning:- when you negotiate an equity deal the terms are often more important than the price- increasing convertible debt deals are being done with a cap so price enters the discussion. actually, many convertible deals specifically avoid some of the terms, which is why some people like them. they think it goes faster. my point is that your avoiding the discussion and could later find out you’re out of alignment on terms with you investors. why would you want that- any entrepreneur who raises money and sees it as “just money” is naive. If Fred’s money the same as Joe Bloggs? Would you pay a slight premium (in dilution) for Fred’s money? If I were an entrepreneur I would- I hate “put” and “call” features in deals. The number one thing that kills “good” deals (e.g. ones where people are interested but not yet committed – as opposed to “great” deals or “bad” deals) is deal complexity. Future potential investors see complex structure and think – ugh – I’ll allocate my time elsewhere. I promise you. I see it all the time.

      1. JLM

        Terms v price = oxygen v water. Everything is important. One over the other?The issue as to whether any particular VC’s money comes with an additional benefit is always important. The additional benefits are the glue which creates a “business” rather than just an “investment” relationship.The importance, to a great extent, is dependent upon the entrepreneur and his personal experience. Having raised over $1B (more importantly having paid back $1B) in my business career, I am probably not as likely to find the investor to be as important as a fresh faced young entrepreneur. Having said that, I am probably MORE rather than LESS concerned about the nature of the investor but it is icing rather than cake.I would hope that it would work both ways — Fred and others would like to do business with someone who had been to the rodeo (pay window?) a few times before and the pricing would reflect that reality.A convertible debt structure by its very nature is a “put” and to balance it with a “call” is not unduly complex — otherwise I agree completely with your attraction to simplicity.You bubble up a great point — look at every deal from the perspective of the next deal and anticipate the issues it may give rise to in the future. Great advice.

        1. msuster

          Yes, obviously the more experienced the entrepreneur (and thus the better network, judgment, skills) the less the actual investor might matter (as long as the money you raise comes with limited control and from benign investors). I was arguing more for less experienced oxygen / water – my point precisely. You need to negotiate BOTH. Often convertible debt leaves important issues rodeo – investors almost always prefer to back people who have proven they can ring the cash register.

        2. fredwilson

          my favorite JLM phrase – “the pay window”i can actually envision what ones looks like

          1. RichardF

            me too, funny

          2. Mark Essel

            JLM has an unlimited set of analogies to draw on, and the whit to pull out the right one at the moment.Hey if you check out, hit it from a browser other than IE. Working through some early bugs but it’s pretty functional in Firefox and Chrome (just needs some design tweaks to increase map size, and scale to mobile)

          3. David Semeria

            You have to speed that baby up, Mark.Run yslow and just follow the instructions – and it’ll be going like gr, gr, greased lightning…

          4. Mark Essel

            roger roger!Thanks David.Just talked to a friend in Brazil who liked it. But culturally they don’t do garage sales where he lives. He lives in a city, but I’m surprised folks in Brazil don’t have moving sales.Maybe he can introduce it there.

          5. fredwilson

            do you crawl to find garage sales or do you need the person running the sale to enter it into your system?

          6. Mark Essel

            We crawl a garage search tool now, and we plan on improving our ability to aggregate moving sales from other sites. User contributions are of course preferred, my idea was to give folks points for garage sale spotting (not just their own), but that can come later.We can undercut competitors with freemium and provide users with the advantages of superior tech.Some competition: http://manisteegaragesales….People pay for classifieds, and they’ll pay for being on a map. If we can do it for free for everyone, I’m sure we can monetize -> premier listings and side scrolling ads are at least two ways.Maps make classified ads, and other events better.

        3. Harry DeMott

          Ditto on the “pay window.” As a massive bull riding and rodeo fan, I actually know what you are talking about – which makes it even more funny. Are you in Texas or out West? Not too many PBR fans in the suburbs of NYC.Not much to add to the conversation, I think you have summed it up well. Price and terms are two opposing forces – just as risk and reward help you achieve some point on an investment continuum.I really think what is happening is that there is still a lot of money flooding into earlier and earlier stage deals – so people are moving along that continuum and taking more risk – rationalizing it by thinking that their money is not “equity” when it is in the form of convertible debt – but a first out position – like preferred – however, unless you control the board – you can always be crammed down in any of these deals – so call it preferred equity, or convertible debt or anything else you want – you are equity unless you control everything – the rest is noise.

          1. JLM

            ATX — Austin, Texas — 310F today.

      2. Mark Essel

        Of course the source of the investment and the network they bring to the table needs to be considered. Again it’s important to realize most entrepreneurs will not be funded by the most popular VCs (Fred, yourself, Brad Feld, Dave Mcclure…). Top investor attention is in too high demand, you see so many fantastic deals/teams that it’s highly unlikely a no name first time founder is going to get funded by you.The more likely outcome is funding by VC with a good rep A vs VC with a good rep B.

      3. David Bloom

        Many of my entrepreneur friends look at convertible debt as a simple tool for raising early money. But I’ve heard about convertible debt deals that have tricky rights and structures. The effort to come up with these terms seems like a terrible distraction from the million unavoidable critical tasks and adds complexity to later rounds. I lost some investors who wanted special rights but ultimately my friends and family round was fully subscribed. I wonder if you’ve ever walked from a deal because of the terms in previous rounds.If you are raising from generic investors, money is more or less generic. In such cases, my (albeit limited) experience is to raise fast and start spending. I suspect this is the right mindset for 99% of rounds. I lost time and sleep worrying about price and structure for my friends and family round. A rookie mistake. But when an entrepreneur is raising from a branded investor the calculation changes. The money comes with social value, connections, and experience. Money from Ron Conway is not the same as money from my parents (no offense, mom).

    3. Deckerton

      This is a good point. Entrepreneurs can be obsessed about their customers, delivering great products, and creating long term value. They can also be obsessed about cleverly structuring their financing. I think it’s exceedingly difficult to be obsessed about all of the above. What type of entrepreneur do we want to encourage?

    4. hardaway

      Well, that’s right, and that’s what I’ve been helping people focus on by making my deals simple. Now all of a sudden I learn I am doing it wrong? Always willing to learn more:-)

    5. foxnewsdigital

      great article

  8. CliffElam

    As a guy who *way* overpriced his angel round in the last-but-one bubble, I’d have been much better off with a convertible round with a kicker and a base. I might even have been smart enough to take it.To explain: we raised just south of a million at a $5M pre. I am a very very frugal guy so this got us our major milestones (channel, product, international expansion, sales, technology) and enough time to get to a term sheet and finally a sale. But it also put us in a funny place for a professional round – price was a bit high, etc.I’d have been much better off, and so would my angels, if I’d been easily able to drop the professional round down to $3M or $4M. I think the VC’s probably would have like the deal better too.-XCPS – Five minutes is plenty to nail a valuation. If you haven’t discussed the floor before seeing the VC you should have stayed home.PPS – $5K is a lot of money to save, even today. Back int the day that was a workstation and monitor. Now it would be three.

  9. LECHSAM group

    I think convertible debt is a great tool for seed investments and Fred you made just the point as to why. Your 25+ years of experience does not represent the typical “rich uncle/friend” angel. A vast number of people who pony up seed funds are affluent individuals whose particular area of expertise is outside of finance(venture capital)/valuations. In addition, a sizable number of entrepreneurs looking to get that for $75-$100K are first timers out of the gate and are uncertain of how to accurately value their startup. Given that convertible debt in essence is a loan, it puts some investors at ease when investing in a good idea whose founder(s) track record is not that deep as their funds are not “married” to the startup but its simply courting allowing for an amicable split if at the end of the courtship things have changed… For these reasons (among others), convertible debt works great!

    1. fredwilson

      it is great for thembut not for me

  10. andyswan

    Deal-structures, like money, are just tools. As long as you know how to use them (entrepreneurs, this is KEY), there’s really no right or wrong.The most important thing for most of the entrepreneurs on this board (i.e. EARLY stage) is to START MAKING DEALS. For cash, for traffic, for equity, for exposure….get out there and get working with other people and companies.Know what you’re doing, and DO IT.

  11. msuster

    I’m with you, Fred.I wrote very similar yesterday: http://www.bothsidesoftheta…I think convertible debt is the latest entrepreneurial fad that people don’t totally understand. Specifically I tell people:- you can do negotiated, priced deals for $5-10k- “but we don’t want to negotiate terms – too tough / long” – why would you want to start working with investors without understanding expectations? I wouldn’t. Better to have the mature discussion. Like you, I can negotiate on the spot. For the right early-stage deal with a team that I already know we’ve given them a term sheet the same day.- convertible with no cap is a bad deal for investors. Savvy ones know this. It’s a frothy market so people are willing to do it. But as an entrepreneur if you do it just make sure you don’t choose a lesser investor over this. I’d always maximize for better investor / fixed price. If you CAN get convertible debt with no cap from the exact investors you want – it is mostly better for you. In my blog I talk about a specific case where it’s not. I’ve seen first hand where it does cause some problems.- “convertible debt with a cap” is everybody’s latest favorite thing. I don’t get this. The entrepreneur gets a maximum price (read: your deal IS priced) but no minimum.- If people are obsessed with convertible debt (I don’t know why) then at least ask for “convertible debt with a price” vs. a cap. I know I made this instrument up, but I guess the only advantages are: you don’t yet agree all terms, you supposedly paper faster / cheaper & you get to tell all your friends you have “convertible debt”- mostly I just think price your deals.

    1. Mark Essel

      Now Zemanta, Liad, and yourself have linked to your very complimentary post. Good stuff.While pricing a nascent business is tough, between your post and Fred’s I now have a better understanding of the reasoning behind doing the negotiating early and understanding how a business is priced.I think the major distinction is simply that you and Fred are professional VCs while many of the YC investors are angel/super angels.The upside of convertible debt is that it’s fast for all involved in a round. Not every entrepreneur who gets funded will have the benefit of pro VCs that can do fair pricing on the spot.

      1. msuster

        yeah, but even with angels I’d argue for having the mature discussion and knowing what their expectations are before taking the money. In this day and age you can’t use the excuse that you don’t understand terms. With VentureHacks (won’t link!) you can learn this stuff on the fly.

    2. hardaway

      Maybe you have something to teach me here about pricing. I typically do a very simple deal, because I’m not a professional financier. I would love to sit down with you and learn what all these terms mean, since I’ve been doing $5k and $10k deals for about twenty-five years now with simple amortization. I may be a jerk, but I’ve made money and helped people, and I want to learn how to do it better.

  12. Mark Essel

    “That wave is creating price expansion. It is a seller’s market and will be for some time to come. And then things will settle down. And when they do, I think we will see the angel/seed market return to a more normal place”What if this trend doesn’t slow down? What if it’s more than the effect of leadership, vision, and inspiration from nearly stage funds like YC? There are a couple of trends to look at. How many startups are getting funded today versus annual historic numbers over the past 15 years, and how big are their valuations (or caps) over the same period.

    1. fredwilson

      that’s a possibility markbut every market wave i have seen in the past 25 years has eventually ended

  13. John Frankel

    Spot on.

  14. bussgang

    Fred – thanks for this post. I think you are dead on and was glad to see someone take on the rising tide from angels for convertible debt. It’s not a panacea for entrepreneurs. It can be very appropriate when professional VCs are not involved and the entrepreneur wants to defer pricing the round for the professional VC, but it seems like entrepreneurs that take convertible notes are either providing their angel investors with downside protection, as you point out, or simply deferring a tough conversation about price. Human beings, by nature, avoid and defer tough conversations (our fight or flight instinct runs deep). The convertible note has become too convenient a salve.

    1. Tereza

      Interesting to read through these comments because I asked a ton of folks and quite uniformly I also was advised to do convertible debt-with-timed-cap. So that’s what I did.It wasn’t because I wasn’t avoiding a tough conversation, but rather, a negotiation based on no facts and pure market power (of which I have none). Isn’t it a naval-gazing conversation where I’m at a disadvantage?One professional angel did later scold me on it (after I’d brought in a few investors for convertible debt), and he said other professional angels would avoid it as well. But frankly we were not a good mutual match and neither was his broader network (he is deep tech, I’m a consumer play).And didn’t seem logical to change my tact midstream for a low- to no-probability investor.So if my target angel investor is a marketing- (not tech-) type, does the convertible debt vs. equity debate matter?

      1. bussgang

        Honestly, I think you choose the quality of your partner first and worry about financing structure second. Convertible debt is fine and in the right context, such as the one you’re describing, it could be the best solution. It’s just not a one-size-fits-all.–> If you want to check out my book on VC and entrepreneurship, called Mastering the VC Game, see——————————Jeffrey J. BussgangFlybridge Capital Partners500 Boylston Street, 18th floorBoston, MA 02116E: [email protected]: 617 307-9295F: 617 307-9293Blog: http://www.seeingbothsides.comTwitter:

      2. fredwilson

        i think it is sophisticated vs unsophisticated investors here Terezaif it were me, i would have insisted you price the equity

      3. fredwilson

        i think it is sophisticated vs unsophisticated investors here Terezaif it were me, i would have insisted you price the equity

  15. Steven Goldman

    Hi fred,As you point out it appears to be a sellers market. The angels and seed investors take the biggest risk though so they should have a better grip over the valuation in my mind.I thought about your post on Gmail when I saw the this… I hope it helps!

  16. hardaway

    Because I do such early stage deals, I do convertible debt all the time. It’s better for the entrepreneur and better for me, because sometimes the team doesn’t have its product together, or its IP in place, etc. If it converts, I forget about it, because it’s not likely to be a success. But sometimes I want to get out early, because I’m not a fund, just a person, and I want to go on to the next deal. I can’t get anything on my money in a bank, so…yes, my upside is less, but I view my downside and the entrepreneur’s as less, too. If I took equity, I’d have to be screwing up the guy’s cap table all the time, wouldn’t I?

  17. William Carleton

    Fred, I’m a fan of Ted Wang’s “Series Seed” documents, which offer a standard suite of docs — not just a term sheet, but the charter, purchase agreement, and investors’ rights agreement — for a priced seed financing. I’m doing three right now using these docs, and I happen to know that another firm in Seattle is working a financing using them. Maybe Paul Graham has a standard note suite but in my market there are many variant forms of notes and note terms; it’s not unusual for a note terms to be highly negotiated, esp. when you have experienced investors participating. There are other virtues and drawbacks (the Series Seed does not have the investor protections that, I believe, you likely require for a typical Series A) but the messaging out there right now, that notes are always cheaper, worries me a bit. Notes have their place, but I think the rage for them may suggest to some founders that basic organizational stuff can be put off, too, not just setting a valuation.

    1. fredwilson

      there are a handful of “non negotiated light series A” docs floating aroundted’s are very goodwe haven’t used them yet but we would if an entrepreneur asked us to

  18. Florian Feder

    You are funny, Fred. “I can negotiate a fair price with an entrepreneur in five minutes […].” I am sure you can only do that if you and your counterparty are pretty clear about the market value ahead of time, i.e. if you have a good idea of where the market is. Right now the market is at a place where the entrepreneur will confidently offer you (convertible) debt. You, however, want equity. If you want that negotiation to be done in five minutes, then you better agree to debt.

    1. fredwilson

      or pass on the deal which is what i do every day

      1. David Semeria

        This is why today’s post is less useful than your usual ones.You’re explaining why you don’t like convertibles, not why the market shouldn’t.In the same way that you can confidently cover valuation in 5 minutes, you can also walk away from just about any deal that comes your way — and you can do both these things because of your hard work in the past.Many other investors, certainly angels, are not in the same position — which probably explains the current popularity of convertibles.

        1. fredwilson

          you are right davidbut i am not sure what the market should “like” in this case

  19. Michael Langer

    It does seem that with Convertible Debt the investor and Entrepreneur have diverting interests as to when the next round should be taken and at what valuation.

  20. AnujMathur

    i was trained initially as a credit analyst at a convertible focused hedge fund, and have spent my entire career investing in convertibles in both the public and private markets .. i understand the postives/negatives of this structure, but believe there are more positives then negatives ..i think it’s important to understand that a convert is useful tool to implement change .. there’s a lot of value in that .. here’s an example of an investment i made that ended up being beneficial to everyone involved (on the basis of return on investment):in 2005 i had made a small equity investment in a company that had developed a very efficient display technology for both government and private applications .. i loved the technology, and the company had already begun generating revenue with government agencies .. i had two major concerns: 1) the company had been stuck using old processes and was moving too slowly along its R&D roadmap and 2) the company should have had far more traction by now .. i had my views on the reasons for these concerns, but i couldn’t be certain 2006, the company needed more capital .. i had learned a lot about the potential of the technology, and wanted to participate in a bigger way .. i also learned that certain behaviors perpetuated by incumbent leaders were the likely causes behind my concerns (listed above) .. replacing incumbent management, especially when founders isn’t easy .. i didn’t have board control, and i didn’t have the support of enough shareholders i decided that another equity investment was too risky, and chose to lead the new round with a proposal for a convert + warrants .. i was careful to implement certain protective covenants: a) restrictions on raising debt senior to the convert; b) board representation for shareholders; c) limits on G&A and d) other performance based covenants ..the company did well, but not as well as it should have .. the debt came due, and the company couldn’t repay or refi, as most of their institutional shareholders were invested in the convert .. we ultimately rolled forward the maturity on the debt in exchange for certain changes .. these changes were not easy to come by – not a pleasant process, but critical ..with new leadership, and very specific performance targets, lots of great things happened: balance sheet was cleaned up, new financing was raised, company culture changed for the better .. .. and performance improved .. soon the company became a cash flow generator, and could fully fund its own expansion ..the convertible investors ended up exiting with an ~30% IRR and ~2.5X multiple .. not a homerun, but i think without the changes we forced with the convert, the company would likely have gone under .. the company continues to do well, and lots of shareholders and management have profited nicely ..

    1. PhilipSugar

      “an investment i made that ended up being beneficial to *everyone* involved (on the basis of return on investment):””replacing incumbent management, especially when founders isn’t easy”Quick question…..I mean this most sincerely. Are the founders reference-able?? Would they give you a good reference?? I really am searching for a case example on this.

      1. AnujMathur

        i certainty wouldn’t ask for a reference from them .. it wasn’t the most pleasant experience for them, and wasn’t for me either .. one founder lost the CEO position, one took a decent pay cut ..i believe that the company was on a trajectory towards zero (bankruptcy maybe, a fire sale more likely) .. ultimately changes were made and the company has been successful ..from my perspective, all investors and shareholders benefited from a process that was facilitated through features of a convert ..

        1. PhilipSugar

          Thanks for the frank reply my quest continues.

  21. PhilipSugar

    I think the elephant in the room that hasn’t been brought up is when does a convertible debt hurt the investor? Plain and simple its when the next valuation comes in really high. The higher it comes the more it hurts (which is why there usually is a cap).So when does this “hurt” turn into a “screw”?It does when the investor has helped get that valuation. Money is money if you’re talking about using it to buy things that have a set value. For instance if I’m raising money to buy foreclosed houses I don’t care as long as its green. The bank doesn’t care if its Fred’s money or mine….they care what price is higher.But in this case if you’re doing a web start-up and you don’t think the difference from taking money from Fred versus me isn’t going to make a world difference in what employees you can attract, what A-list bloggers you can get the attention of, what companies you can get in the door to partner with, then you frankly probably aren’t smart enough to get his money anyway.Which is why he doesn’t want to help you only to have his help hurt him. Even though I am WAAAY down the totem pole I feel the same way versus me and the proverbial rich dentist…..So understand that when you come to him and demand a convertible note versus pricing the deal its going to be insulting….understand that. Now if you are going to investors that aren’t going to help you one bit that’s another thing.And the only point I’d make there is that if they have to say they’re going to help you….they aren’t. Just like the guy who asks “don’t you know who I am???” if you have to ask you’re a nobody.Last point is that sometimes we get so obsessed with price we forget value. I had to negotiate a new car purchase for my father. I’m pretty sure I could have saved $200 buying from an ok dealer that was 20 miles from his house in an ok neighborhood versus a mile from his house top dealer. I know they’re both supposed to service it….but where do you think I bought the car??? And that’s a freaking car.

    1. Mark Essel

      Great comment Phil, and the most poignant point at the end, convenience trumped $’s. That reaction is part of the rationale behind, seeing nearby sales (and events) has value.

  22. Brett Topche

    Another issue I’ve seen from the investor side is that some terms in the convertible debt are not always respected by subsequent investors. I have seen Series B investors push to eliminate the conversion discount on a note, which basically means the Series A guys took a lot of additional risk for zero additional compensation. Particularly for early stage investors who lack the deep pockets to also fully fund a Series B, this is a real risk.

    1. fredwilson

      money talks, always has, always willand when you don’t have any money and need it, the new money will dictate what happens to everyone, including the seed investorsgreat point Brett

      1. OMA

        The best cap table of a company (not necessarily best for investors/founders but best for the company’s long term survival) represents the potential future contribution to the company not past risks.This, naturally, never happens. (and is the reason for repurchase agreement, option pool allocations, pay to play, and probably one or two more terms).Some angle/seed investors, who took a great risk, and some founders who had a great past contribution, have little future contribution. They don’t invest a lot further down the road, and they don’t participate in running the company.I believe in what I wrote above, but feel it’s immoral.Faced with such a situation today, my gut feeling is that I should protect my early investors despite the fact that the good of the company is probably elsewhere.

        1. fredwilson

          it is not your job to protect your early investorsit is their job to do that

          1. daryn

            I don’t think this is exactly right, Fred.It is always your job to protect and add value for your investors – be they early or late – though the best decision for the company and shareholders at any given time may negatively impact some of the investors, and that’s part of the risk they’ve accepted.

          2. Tereza

            Daryn I have to agree with you there.It’s one thing if they are professional investors.But if you’re at friends & family — smart friends and family — and they have some familiarity with startups and VCs — one of the questions they invariably ask is, will you protect me when the VCs try to cram me down?I keep hearing it. And so far my answer has been, hell yes.Is that wrong?

          3. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

          4. OMA

            I can’t allow this to be a multiparty negotiation. I need to close a round and take the company forward as soon as possible.I am the only one negotiating and I will bring a “deal” to my investors.If they decide not to take it, they better back it up with a few millions the company needs.I can take a lower valuation from a better VC with deeper pockets with some nice accelarations and option packages for the employees.I can take less money from a tier 2+ VC at a higher valuation.Its my call.They can’t protect themselves.

          5. fredwilson

            i am with you on this but they can protect themselves if they put up moremoney (as you pointed out)that is why deep pockets matters a lot in the venture capital businessand angel/seed investing is venture capital

          6. OMA

            We’re raising ~$7-10m, our first investors are an $80m fund. It’s out of their league.At best they can participate in the round (that is if the big guy’s allow it).

          7. Brian Magierski

            Just like poker, bankroll matters big time in angel/seed/VC investing … investing in general. Gordon Gekko called it capital reserves. Probably worth a blog series if it does not exist already.

          8. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

          9. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

          10. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

          11. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

          12. fredwilson

            you must protect the companyand you cannot do that sometimes without throwing the early investors underthe busi’ve been thereit hurts

  23. PhilipSugar

    To sum up my too long post:Why would I enter into a relationship where the more I help you the more it hurts me?When I know I am not going to help you.All the other stuff is just words and “principle”. When somebody says its not the money its the principle…its the money.

  24. sbmiller5

    As Fred mentioned, Seth Levine wrote a post on this topic – Mark Suster followed up with a post on Convertible debt vs Equity, now Fred Wilson, Chris Dixon and Jason Mendelson – all respected investor bloggers have weighed in on the topic.What if instead of silo’d discussion happening on each blog – these blogs comments were connected and instead of participating on multiple sites – you are accessing this topic discussion from your original source (ie: commenting and reading comments here at avc), but participating in a global discussion around the topic?If this idea interests you, give me a shout, we’ve been working on for a couple months now.

    1. fredwilson

      friendfeed did a decent job of thati’d be interested in seeing what you have in mind

      1. sbmiller5

        I’ll put together an example with this content and shoot you an email when it’s ready – we’re pre-alpha so I need to talk with my technical guy.My understanding is this is quite different from what friendfeed is doing now, although I could see their technology originally targeting a similar concept and they may have changed based on what they learned in the market (if that’s the case I’d obviously like to be aware)

  25. Ted Wang

    I agree with Fred and have created the Series Seed Documents (available for free at to try and make it easier and cheaper to do early equity. One issue that hasn’t been raised in the comment stream is taxes (one of the two things that are inevitable in life!). Equity (as opposed to debt) may enable investors to get long term capital gains treatment if there is an early sale.I also echo the following issues raised in the comment stream :- Equity costs the same (or even less if you are using Series Seed documents which are pre-negotiated);- Gives investors some voting rights which is important from a fiduciary perspective if you are a General Partner of a fund investing limited partners’ money;- Less likely that later investors will alter your rights in subsequent financing;In my opinion, the reason convertible debt is the market leader is that entrepreneurs have become conditioned to think that debt is faster, cheaper and better than equity. Advances like the Series Seed Documents (and other efforts in this area) make this no longer the case. I think it will take a while for this realization to move through the ecosystem, but it should eventually do so.Of course, capped convertible debt is a fine solution and I use it all the time with both VC and company clients. It’s just a suboptimal structure for a number of technical reasons.

    1. fredwilson

      thanks so much for stopping by and sharing your views Tedi expect you see more of the market than any of us commenting here

      1. Ted Wang

        Timing is great for this debate because I just published the new version of the Series Seed Documents and have a post on why they are better than priced convertible debt.

    2. Ivan

      I think the other scenario that I’m seeing a lot of this summer is convertible debt being slower and more expensive that equity! I think this is in part because the speed of the evolution in the last 18 months or so from notes with warrants to straight discounts to discount with cap, etc. has left an unclear playing field on what is “market,” and I also think the hype around angel/super angel/uberangel has drawn lots of new folks to the party; some of whom can be wildly out of step and produce a disproportionate amount of friction. It’s generally workable when you have a clear leader in the round (or your blessed with a “syndicate” of angels who invest together a lot and have a strong consensus around terms) but… You get 6 or 7 folks in a round all doing roughly equal investment amounts and each trying to optimize on their pet terms and it’s a bit of a cluster fuck. There are certainly some “syndicates” out there who you often see investing together in the same deals and have a strong sense of what terms they like and things can be done efficiently, but I’ve also seen a lot of $25K investors generating $25K of legal fees with wacky issues and/or over-optimizing for corner cases. When I was starting out in the business the senior guys would always point out that the top early stage investors typically gave the cleanest terms because they understood that you don’t win big on terms, you win big on getting into the good deals early and pricing them right.

      1. fredwilson

        when “market” is changing that fast, i would tend to stay out of that market

  26. Erick Schonfeld

    Fred, isn’t it often an issue of expediency and less paperwork? If you are doing a small seed round of a few hundred thousand dollars, I’ve heard it is just faster to do the convert and deal with all the paperwork later on when the company raises the A. This is appealing to founders who want to get back to building their business as quickly as possible.

    1. fredwilson

      i think the “non negotiated srs a documents” are just as fast and just as cheapthe key is not negotiating anything

  27. ShanaC

    Of those who are semi-savvy, how much is the choice of debt driven by the economy – interests rates are close to 0, making money itself cheap. I keep thinking the combo of “we’re not swinging for the fences” and “convertible debt as a choice” is some sort of signal about the state of where we are now- even if there is no hard asset, the soft assets are much more tangible and seizable, something of an assurance in a weak economic state.However, it’s more of a question than an answer

    1. PhilipSugar

      Nobody’s raising money in this fashion without projecting that they’re swinging for the fences.And since you’re not buying tangible assets you’re paying salaries the “soft” assets are worthless.Lets take a hypothetical example. Lets say I proposed to Fred that I was going to build a SaaS company that was going to service plumbers. The back end of the office. If I raised $500k I could get things going and hit break-even getting 100 shops to pay me $300/month in 18 months having a super lean staff. In seven years I could have 700 shops and be net growing 100 shops a year. I could give him twice his money back its a good business, but that business just isn’t going to sell for a ten xer. That just doesn’t work in this context….however, I think I’d have an easier time convincing him than going to the bank.

      1. ShanaC

        Which is why I’m thinking people are switching over to CD in the first place. If we’re seeing lots of those sorts of companies being built (we’ve been through this about seed funding and a possible bubble) why would you go for equity unless you are building something that does swing for the fences? Is this a period of small tech in the US because we don’t want to make big bets?

  28. Steven Kane

    respect to paul graham et albut fred, you are sooo righty combinator aside, convertible debt is good only for amateurs and “spray and pray” investors

  29. telanon

    Consider the case of a startup with a prototype and a series of milestones ahead — customer evaluations, customer contracts, pilot launch, and achieving product-market fit. A normal Series A preferred round is planned after the last milestone.What is the best way to finance the company until the planned Series A? One alternative is a “light preferred” such as Series Seed. A likely problem is that raising enough to reach all the milestones can be very dilutive to the common-stock holders (founders and friends/family investors). A string of smaller “light preferred” rounds to get there could be priced appropriately at each milestone, but would involve legal expenses each time. Plus that creates multiple “light preferred” classes of stock and related logistics issues.Another alternative is the “rolling close” convertible debt with multiple price-conversion caps like Paul Graham mentioned in his “The Future of Startup Funding” post and John Bautista in his August 5th blog post. Investment made by earlier deadlines gets the advantage of lower price-conversion caps, with deadlines that can be set when significant milestones should be achieved. This single financing structure, and single set of legal fees, could serve the startup’s needs until the planned Series A.Assuming the price-conversion caps are reasonable, wouldn’t this convertible-debt structure serve both the startup’s and investors’ interests better than a single “light preferred” round or series of them? The definition of “reasonable” might be Wilson Sonsini attorney Yoichiro Taku’s observation that “The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.” The first-deadline price cap would start at the low end of this range, and the last-deadline price cap would not exceed the top end.

    1. fredwilson

      i don’t see any difference between a series of small light preferred roundsand convertible debt rounds and would suggest the former

    2. fredwilson

      i don’t see any difference between a series of small light preferred roundsand convertible debt rounds and would suggest the former

      1. telanon

        If I understand it properly, the difference is one convertible debt round with multiple closings versus multiple light preferred rounds. It involves one-time legal fees and negotiations versus multiple sets of legal fees and negotations.If there’s a way to structure one light preferred round with multiple closings at different prices at different times, then I don’t see much difference either. I haven’t seen any discussion of that approach, though, so I don’t know if it’s an alternative.

        1. fredwilson

          we do the latter all the timeone set of documents, multiple pricesseries A-1, A-2, A-3, A-4, A-5, etc, etc

        2. fredwilson

          we do the latter all the timeone set of documents, multiple pricesseries A-1, A-2, A-3, A-4, A-5, etc, etc

        3. fredwilson

          we do the latter all the timeone set of documents, multiple pricesseries A-1, A-2, A-3, A-4, A-5, etc, etc

        4. fredwilson

          we do the latter all the timeone set of documents, multiple pricesseries A-1, A-2, A-3, A-4, A-5, etc, etc

        5. fredwilson

          we do the latter all the timeone set of documents, multiple pricesseries A-1, A-2, A-3, A-4, A-5, etc, etc

          1. telanon

            Are the prices all negotiated up front, or each time you and the startup are ready to issue the next sub-round (A-2, A-3, etc. vs. the initial A-1)?

          2. fredwilson

            prices are negotiated when the money comes ini am not a fan of negotiating future valuations in advancesets all the wrong incentives

          3. fredwilson

            prices are negotiated when the money comes ini am not a fan of negotiating future valuations in advancesets all the wrong incentives

          4. telanon

            I just found Paul Graham’s post “High Resolution Fundraising”, which came after his “The Future of Startup Funding” that helped trigger the recent discussions of convertible debt vs. preferred stock. I think you and he may be focused on different advantages of “light preferred” with multiple issues each priced at time of investment, but if I’m not mistaken I think you may now both agree it is a good alternative for seed-stage fundraising.Here is the relevant quote from Graham’s essay:”Different terms for different investors is clearly the way of the future. Markets always evolve toward higher resolution. You may not need to use convertible notes to do it. With sufficiently lightweight standardized equity terms (and some changes in investors’ and lawyers’ expectations about equity rounds) you might be able to do the same thing with equity instead of debt. Either would be fine with startups, so long as they can easily change their valuation.”The entire essay is here:… .

          5. fredwilson

            paul and i have been debating thisi think equity is way better for hi def fundraising than debt

  30. RJ Johnston

    LOL! I may do it, but I won’t like it – another great article, thank you Fred.

  31. ian_peterscampbell

    I’m probably being naive, but if the issue is strictly one of financing (rather than an issue of company control) is it always a bad thing for an entrepreneur to give up an extra point or two to early investors? Of course I as an entrepreneur would want a good deal, but (and here is where my naivete comes into play) it seems like I might have more to gain from happy investors than an extra shaving of equity. Aren’t there advantages to having a happy household in which everyone has strong incentive to work toward common success? Of course the early investors aren’t going to drive the success of the company on a day-to-day basis, but wouldn’t I rather be in business with people who really want to take my phone calls, make introductions, really go to bat for the company when called upon? Why would I want to involve someone who was going to be less than happy with the terms who would drag their feet or be sullen when I needed them in the future?If the company succeeds it’s not like my pockets are going to be empty either way, unless there’s such severe dilution in later rounds that none of this matters. Again I may be naive and not understand the realities of the space, but in most of life I’ve found that pushing for the best possible deal is often not as advantageous in the end as a deal that leaves a little something on the table and ensures that everyone involved walks away happy.(and please don’t anyone be afraid to set me straight if I’m chock full of crazy.)

  32. fredwilson

    i agree charliethis post was about why i am not excited about that structurei agree it is a good one with unsophisticated investors

  33. johnmccarthy

    Not sure that CD is $5K cheaper than the a light Series A. Taking as a given the $5K for the A, there will still be legal costs associated with a CD. How much is the question. But any entrepreneur that accepts someone else’s money, using any structure that doesn’t consult an attorney for a review of the documentation is asking for trouble.

  34. nikiscevak

    Back to the original reason for Fred’s post though – pg’s tweet – how would that logic stackup for the investors who are backing the current crop of ycombinator companies? The folks involved are all fairly seasoned angel investors and some are quasi-institutional. And at the very least they have been through fundraising paths on the other side of the table as entrepreneurs.

  35. nakisnakis

    Hi Fred,I’m considering convertible debt for investments made through Pipeline’s new initiative, the Fund, given our target demographic: first-time investors.The Fund has three goals:- Convert women philanthropists into investors- Increase the number of women on boards- Provide funding to women-led triple-bottom line for-profit startups in the range of US$50k-US$500kFor our pilot, we will accept a class of ten women who will each invest US$5k, US$50k collectively, into a business they will select after going through a six-month training (modules include: board governance, valuation, due diligence, etc.).We’re providing participants with an applied learning experience and convertible debt seems like a good fit for their first investment.I would appreciate any advice you may have and hope to continue the conversation in-person. Thanks in advance for your time and interest!Best,natalia

  36. Zeke Vermillion

    Why not raise seed money using warrants convertible into common equity?All the features people seem to like in convertible notes can be had with warrants (or options). You can provide for the conversion price to increase over time, and you can delay negotiating a stockholders’ agreement and papering the other aspects of issuing stock until conversion. The only feature inherent to a note, which is that its holder will enjoy creditor status in a bankruptcy or liquidation, is rarely mentioned, although this is clearly adverse to founders and probably not of much interest to seed investors unless the startup has significant assets.In fact, all of the convertible note deals I’ve worked on as a deal lawyer have been for a fixed conversion price, adjusted for paid-in-kind interest and anti-dilution protection. And when I lined up seed money to develop a semantic data application as an entrepreneur, friendly investors, some of them lawyers, were happy to invest in warrants convertible into common stock. I ended up putting the deal on hold for other reasons — I lost my technical co-founders to very interesting and well-paid day job opportunities — but the lasting impression I had was that friendly seed investors will put money into whatever instrument you suggest as long as they know you personally and trust you not to give them a bad deal.

  37. fredwilson

    if the goal is training people to be investors, you should train them to price rounds, not punt on that

  38. nakisnakis

    Thanks for the feedback. Would love to have you as a guest speaker at some point during the training.