This is the third of three articles on Convertible Notes for founding entrepreneurs. Convertible Notes Part One: The Basics defined what a Convertible Note is and compared it to Preferred Stock. Convertible Notes Part Two: The Crucial Details examined how negotiations arrive at Convertible Notes. This article identifies 7 reasons that Convertible Notes are the wrong way to go.
You’re Strong Enough to Get a Loan
If your company is destined to be the next Facebook sensation, you’ll make the most money by delaying sale of your company. To do that, you’ll have to convince someone that you can safely pay off a loan, with interest. If you’re strong enough to do that—and you think your company will appreciate—don’t sell off future rights to your company. Get a Loan.
You Can’t Afford to Pay Interest
Convertible Notes can let you delay the date when you sell your company, but they come with the cost of paying/accruing interest until that time. Every business is different, and yours could have a bright future while still being unable to make interest payments. If you can’t afford interest now, then you need to consider equity instruments like Preferred and Common Stock. Keep in mind that there needs to be a good reason that the future will be brighter than the present for investors to take you seriously.
You Aren’t Good at Terms
Convertible Notes offer more flexibility. While that can work to your favor, it can also work against you. Setting a fair cap, discount and interest rate are the important terms for when your valuation goes up…but what if your valuation goes down? Unless you can see the future, you need to consider all possibilities. Conversion rights in case of lower valuation are important and can lead to anathemas like Full Ratchet. If your Convertible Note includes the wrong Liquidation Preferences, any unfortunate need for liquidation could leave you with a lower effective ownership percentage than you’re comfortable with. But in the end, if you can’t negotiate the flexible terms of a convertible note, you’re going to have a really hard time with the rigid terms of an actual term sheet.
You Can’t Agree on Terms
Being good at terms doesn’t mean you’ll be able to get the terms that you want. Convertible Notes have more flexibility, but savvy investors will want to use that flexibility to their advantage just like you’re hoping to use it to yours. Sometimes more established, less flexible forms of funding will result in less arm wrestling. If the terms you can get from another funding instrument are better, the flexibility of Convertible Notes may not mean much. If that’s the case, get Series funding.
You Don’t Have a Long-Term Plan
Convertible Notes can let you price investors differently—giving you more negotiating power—but pricing investors differently comes with a cost of higher complexity down the road. The higher complexity can cost you more in legal fees and limit your options when you’re ready for your next round. That may be an acceptable cost, but it shouldn’t ever be a surprising cost. Don’t let short-term pressures keep you from considering the long term.
You Don’t Understand the Gamble
All investments are a gamble, but Convertible Notes act as both debt and equity, meaning you don’t get to dodge the risk of either. That higher complexity isn’t necessarily a bad thing, but it shouldn’t be mistaken for a good thing either. A good gambler is one who considers all possibilities, correctly estimates the probability of each (beta), and makes sure the terms of the agreement are better than the risk (alpha). The terms of your Convertible Note will determine what kind of a gamble you’re taking. If you don’t understand the gamble enough to decide whether you like it or not, you shouldn’t be taking it. Get help or stick to less complex financial instruments.
You Don’t Need To Retain Control
With all these pitfalls, you might be wondering why it is you should like Convertible Notes in the first place. The reason is simple: flexibility and control. Flexibility can (sometimes) let you raise money quicker, with fewer legal fees, and negotiate stronger. Frequently founders use their flexibility to maintain higher levels of control, keeping their investors off of the board, and keeping their investors from having veto rights on future rounds of funding. If you need neither flexibility for unusual terms nor more control than typical Series funding will provide, Convertible Notes hold little value for you.
Next Steps
Each of these pitfalls requires expert analysis to be correctly evaluated. That means you need an experienced CFO. While a full time CFO can be too costly, lacking at least a part time CFO can be more costly. While hiring a temporary CFO is an option, businesses inviting investor funding benefit from a lasting solution. An outsourced CFO is the most cost-effective way to buy long-term expert advice while avoiding the heavy cost of an expensive internal officer.
Please speak with Preferred CFO for a personalized analysis.
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