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The Convertible Note Trap: They Look Easy, But They'll Cost You Your Company
I've seen it a hundred times. A founder, bright-eyed and full of hope, comes to me for advice. They've got a great idea, a solid team, and a pitch deck that could sell ice to an Eskimo. But then they tell me they're raising their first round on a convertible note, and my heart sinks.
"Everyone says it's the easiest way to get started," they'll say. And they're not wrong. It is easy. That's the problem. Convertible notes are like a Venus flytrap for first-time founders. They look harmless, even inviting. But once you're in, they can be incredibly difficult to get out of, and they can end up costing you a lot more than you think.
I should know. I've been on both sides of the table. As a founder, I've raised money on convertible notes. As an investor, I've put money into companies using them. And I can tell you from experience that they are almost always a better deal for the investor than they are for the founder.
The Valuation Cap: A Ticking Time Bomb
The biggest problem with convertible notes is the valuation cap. For those of you who don't know, the valuation cap is a clause that sets a maximum valuation at which the note will convert into equity. So, if you raise money on a convertible note with a $5 million valuation cap, and your company is later valued at $10 million, your early investors will get to buy shares at a 50% discount.
Sounds fair, right? After all, they took a risk on you when you were just starting out. But here's the thing: that valuation cap is a ticking time bomb. The longer it takes you to raise your next round of funding, the more of your company you're giving away. And if you're a first-time founder, it's probably going to take you longer than you think.
I once invested in a company that had raised its first round on a convertible note with a $3 million valuation cap. The founders were brilliant, and they had a great product. But they struggled to get traction, and it took them two years to raise their Series A. By the time they finally did, the company was valued at $15 million. But because of that valuation cap, their early investors got to buy shares at a massive discount. The founders ended up with a much smaller stake in their own company than they should have.
The Discount Rate: Not as Good as It Sounds
Another thing to watch out for is the discount rate. The discount rate is a percentage discount that your early investors will get when they convert their note into equity. So, if you have a 20% discount rate, your investors will get to buy shares at a 20% discount to the price of your next round.
Again, this sounds fair. But the discount rate can be misleading. For one thing, it's often not as big of a discount as it sounds. A 20% discount on a $10 million valuation is only a $2 million difference. And if you're a hot company, you're probably going to be able to negotiate a much better price than that anyway.
But the bigger problem with the discount rate is that it can create a conflict of interest between you and your investors. Your investors are incentivized to keep the valuation of your next round as low as possible, so they can get a bigger discount. This can make it harder to raise money, and it can put you in a tough negotiating position.
The Pro-Rata Rights Problem
Pro-rata rights are the right to invest in future funding rounds to maintain your ownership percentage. They are a standard part of most venture capital deals. But when they're attached to a convertible note, they can be a real headache.
The problem is that it's not always clear how to calculate the pro-rata rights for a convertible note. Do you base it on the amount of the note? The valuation cap? The discount rate? There's no standard answer, and it can lead to a lot of confusion and disagreement down the road.
I once saw a deal fall apart because the founders and the investors couldn't agree on how to calculate the pro-rata rights for a convertible note. It was a mess, and it could have been avoided if they had just used a different financing instrument.
The Alternatives: SAFEs and Revenue-Based Financing
So, if convertible notes are so bad, what are the alternatives? The good news is that there are a couple of other options that are much more founder-friendly.
The first is the SAFE (Simple Agreement for Future Equity). SAFEs were created by Y Combinator, and they're a great alternative to convertible notes. They're simple, they're transparent, and they don't have all of the hidden costs and complexities of convertible notes.
The second alternative is revenue-based financing. Revenue-based financing is a good option for companies that are already generating revenue. With revenue-based financing, you get a loan from an investor, and you pay it back with a percentage of your monthly revenue. It's a great way to get the capital you need without giving up any equity in your company.
How to Win
If you absolutely have to raise money on a convertible note, there are a few things you can do to protect yourself.
First, try to get the highest valuation cap you can. The higher the cap, the less of your company you'll be giving away.
Second, try to get the lowest discount rate you can. The lower the discount, the better.
Third, try to avoid giving away any pro-rata rights. If you have to give them away, make sure you have a clear understanding of how they will be calculated.
And finally, don't be afraid to walk away from a deal if you're not happy with the terms. There are plenty of other investors out there, and you don't have to take the first offer that comes along.
The Bottom Line
Convertible notes are a tool, and like any tool, they can be used for good or for evil. They can be a great way to get your company off the ground, but they can also be a trap that can cost you your company.
If you're a first-time founder, I would strongly advise you to avoid convertible notes if at all possible. There are better options out there. But if you have to use them, make sure you know what you're getting into. And don't be afraid to negotiate for better terms. Your company is worth it. ''')) HBox(children=(FloatProgress(value=0.0, bar_style=
Frequently Asked Questions
What experience informs this perspective?
This perspective comes from over a decade of building companies in Silicon Valley, two successful exits (RemoteTeam to Gusto, MovieLaLa to Gfycat), and investing in 200+ startups including Anthropic, OpenAI, and Scale AI. I write about what I've lived.
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.
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.