I’ve seen over 500 pitches in the last year alone. And I’m not talking about a quick glance at a deck. I’m talking about sitting down, listening to the founder’s story, and digging into their numbers. And after all those meetings, one thing has become painfully clear: 90% of founders are getting absolutely fleeced on their convertible notes.
It’s not entirely their fault. The startup world is full of jargon and complex financial instruments. And convertible notes are one of the most misunderstood. They’re often pitched as a “simple” and “founder-friendly” way to raise money. But the truth is, they can be a death trap if you don’t know what you’re doing.
I’ve been on both sides of the table. I’ve raised money with convertible notes for my own companies, RemoteTeam and MovieLaLa. And I’ve invested in over 200 startups, including some of the biggest names in the game like Anthropic, OpenAI, and Scale AI. I’ve seen firsthand how a poorly structured convertible note can destroy a company’s cap table and sink its chances of raising future rounds.
But I’ve also seen how a well-structured note can be a powerful tool for both founders and investors. It can help you close a round quickly, without getting bogged down in a priced equity round. And it can give you the flexibility you need to hit your milestones and increase your valuation before your next fundraise.
So, what’s the secret? How do the top 1% of founders navigate the treacherous waters of convertible notes? It’s not about having a fancy lawyer or a degree in finance. It’s about understanding the game and knowing which levers to pull.
The Convertible Note Shell Game
The biggest problem with convertible notes is that they defer the valuation conversation. And that’s where most founders get into trouble. They’re so focused on the valuation cap and the discount that they forget about the other terms that can have a much bigger impact on their ownership and control.
I once saw a founder who had raised a $1 million seed round on a convertible note with a $10 million cap and a 20% discount. They were thrilled. They thought they had gotten a great deal. But what they didn’t realize was that their note had a “full ratchet” anti-dilution provision. This meant that if they raised their next round at a lower valuation, the seed investors’ shares would be repriced to the new, lower price. And that’s exactly what happened. The company hit a rough patch and had to raise their Series A at a $5 million valuation. The seed investors’ ownership doubled, and the founders’ equity was cut in half. They had been completely wiped out.
This is just one example of the many ways that convertible notes can go wrong. And it’s why you need to be so careful when you’re negotiating them. You need to understand every single term in the note, and you need to be prepared to walk away if you don’t get the terms you want.
The Top 1% Playbook
So, how do you avoid the convertible note trap? Here’s the playbook that I’ve seen the top 1% of founders use to raise money on their own terms.
1. Set a Valuation Cap That You Can Justify
The valuation cap is the most important term in a convertible note. It sets the maximum valuation at which the note will convert into equity. And it’s the term that you’ll spend the most time negotiating.
Most founders make the mistake of setting a valuation cap that is too high. They think that a higher cap will mean less dilution. But the opposite is often true. A high cap can make it harder to raise your next round, and it can lead to a down round if you don’t hit your milestones.
So, how do you set a valuation cap that is both fair and justifiable? The key is to have a clear and realistic plan for how you’re going to use the money you’re raising. You need to be able to show investors that you have a credible path to hitting the milestones that will justify the cap.
When I was raising money for RemoteTeam, we set a valuation cap of $8 million. We were able to justify this cap by showing investors that we had a working product, a growing user base, and a clear path to profitability. We also had a strong team with a proven track record. This gave investors the confidence they needed to invest at that valuation.
2. Negotiate a Reasonable Discount
The discount is the second most important term in a convertible note. It’s the discount that investors will receive on the price of the shares when the note converts into equity. And it’s another term that you’ll need to negotiate carefully.
Most founders make the mistake of giving away too much of a discount. They think that a higher discount will make their note more attractive to investors. But a high discount can lead to significant dilution, and it can make it harder to raise your next round.
So, what’s a reasonable discount? In today’s market, a discount of 10-20% is standard. Anything higher than that should be a red flag. And if an investor is asking for a discount of 30% or more, you should probably walk away.
3. Avoid Uncapped Notes at All Costs
An uncapped note is a convertible note that does not have a valuation cap. This means that the note will convert into equity at the valuation of your next round, whatever that may be. And it’s a recipe for disaster.
I’ve seen so many founders get burned by uncapped notes. They think that they’re getting a great deal because they’re not setting a valuation. But what they don’t realize is that they’re giving away a blank check to their investors. If the company takes off and raises its next round at a high valuation, the early investors will get a massive return, and the founders will be left with a tiny sliver of the company.
If an investor is pushing for an uncapped note, it’s a huge red flag. It means that they’re not confident in your ability to build a valuable company. And it means that they’re trying to take advantage of you. Don’t fall for it. Always insist on a valuation cap.
4. Understand the Pro-Rata Rights
Pro-rata rights give investors the right to participate in your future funding rounds. This means that they can maintain their ownership percentage in the company as it grows. And it’s a term that you need to understand very carefully.
Most founders don’t think about pro-rata rights when they’re raising a seed round. But they can have a huge impact on your ability to raise future rounds. If you give all of your seed investors pro-rata rights, you may not have enough room in your Series A for new investors. And this can make it much harder to close the round.
So, what’s the solution? The key is to be selective about who you give pro-rata rights to. You should only give them to your most strategic investors, the ones who can provide the most value to the company. And you should limit the amount of the round that they can take.
The Bottom Line
Convertible notes can be a great way to raise money for your startup. But they can also be a minefield. If you’re not careful, you can end up giving away a huge chunk of your company for a fraction of what it’s worth.
So, before you sign on the dotted line, make sure you understand every single term in the note. And don’t be afraid to walk away if you don’t get the terms you want. Your company’s future depends on it.
Frequently Asked Questions
How has this view evolved over time?
My thinking on most topics has changed significantly over the years. Early in my career, I held many conventional views that experience proved wrong. I try to update my beliefs when the evidence changes.
Do all experts agree with this view?
No, and that's fine. The best ideas in business are often contrarian. I share my perspective based on my experience and data, but I encourage you to seek out opposing viewpoints and form your own conclusions.
How can I apply this thinking to my own situation?
Start by identifying the core principle behind the opinion, not the specific example. Then ask yourself: does this principle apply to my context? If yes, test it in a small, low-risk way before going all in.
What's the most common pushback you get on this?
People often push back by citing exceptions or edge cases. And they're usually right that exceptions exist. But building a strategy around exceptions rather than patterns is a losing game for most founders.