Ten months ago, venture financing was as foreign to me as crocheting.
You start with some yarn (or something like that) and then using some stick things you end up with a scarf (or something like that). For financing you start with a business proposition, you find some investors, and out pops a check.
Fifteen angel pitches, and twenty-seven venture pitches later– I now know that raising money is in fact much more complicated than crocheting (or perhaps more accurately– at least you don't need an attorney to help you finish that scarf).
The goal of this post is to establish a simple mental model that should save any first-time entrepreneur some significant time and headache. I'll try to keep most of this pretty high level because there are tons of great resources out there once you're ready for a deep dive (Venture Deals).
A few upfront disclaimers: 1) I am by no means- an expert, just a first time entrepreneur with some air miles under my belt that I've come to learn are worth sharing. 2) Everyone's venture is unique, what has worked for me may very well fail to work for you. 3) Don't' ask me for introductions to our investors– it's tacky, and if I think what you're working on is interesting they'll probably hear about it at some point anyway.
It gets pretty wordy down below so for the sake of brevity here's the TLDR.
TL;DR - Understand how priced financings work before trying to wrap your head around convertible notes. Because notes convert into your next priced financing, there's a lot of early decision making that you'll have to leave up to your attorney and investors if you don't understand how priced offerings work. Think of this time spent up front as a personal investment in your company, as it will give you the foresight to optimize for future rounds.
Here's my attempt at a "quick," plain English breakdown of what all of this actually means.
Nowadays (generically speaking), when you go out and raise your first slice of capital, you'll do so on a convertible note.
Notes are used at the earliest stage of financing to create a certain amount of flexibility for both entrepreneur and investor. It creates flexibility for the entrepreneur by not forcing the investor to determine the value of the company at a stage that generally would return unsavory results. AKA, if you're a team of smart guys/gals and you're raising money pre-product, it might be fair to say that your company is worth less than $1M on the open market in its present state. Assuming you're playing the VC game, and aim to build a $100M business, it would be lame to give away a huge chunk of your company for a small sum of start-up capital… Enter, "The Convertible Note."
Casually speaking, what is a Convertible Note, and what does it mean for my company?
A convertible note is a document that promises the issuance of shares upon the closing of a future issuance of stock (Qualified Equity Financing or "QEF"). When you sign a note, shares are not actually priced and issued to the investors, but rather held until the price has been set 6-18 months down the road (again, generalizing). Once the price is set, the note will convert into stock at the price deemed at the time of the QEF subject to any Note Cap, and/or Discount.
Instead of forcing the investor to price the round, a convertible note allows the investor to place an early bet, cap his risk, and receive a discount towards future investment. The "Note Cap" acts as a security blanket for the investor so that he or she is guaranteed to take a minimum stake in the company as deemed per the Cap. If this is your first go-round, and you don't come from some sort of world class tech pedigree, you'll almost certainly be working with a capped note (though sometimes you do see uncapped notes flying around).
Expanding on the example of this pre-product company raising money on a note, the investor and entrepreneur might set a cap of $4M pre-money, basically stating that no matter what the priced valuation ends up being down the road (maybe you blow up and your next round is priced at $15M), the early stage investors will convert at the capped $4M valuation rather than the rest of the investors at $15M. (This is the upside of a note for investors that I referenced earlier). This is also generally subject to some sort of discount so they'll end up with a bit of a spiff off the top.
THAT SAID, I didn't write this post to explain what a convertible note does, I wrote this post because I believe that before you can truly understand convertible notes, you must first understand priced financings.
A priced financing is when you and an investor agree that your company is presently worth $(X)M pre-money and based on that number, and the number of shares outstanding, the investor takes Y shares to equal Z% ownership. It's pretty straightforward.
A simple example of this: let's say I want to invest in an apple. I agree with the shop owner that this apple is worth $2 pre-money (pre-money = before I make my investment). I then decide to make a $1 investment in the Apple, and as a result, I now own 33.3% of an apple that is now worth $3 (post-money).
It's important to bear in mind that investment has just as much to do with Control as it does with Ownership. Generally speaking, these are the two dials that get turned when negotiating a term sheet.
SO HERE'S THE RUB: If everything that you agree to in a Convertible Note, ends up translating into a certain amount of ownership and control once it's mashed up with the terms set in a QEF 6-12 months down the road, wouldn't you want to know what those terms might look like, and how this present note will effect the future round?!?
I think the answer is yes. I think everything written above becomes MUCH easier to understand if you first wrap your head around what a priced financing looks like. More importantly, you'll be able to make smarter decisions re: early negotiations. So do yourself a favor– go read Venture Deals, learn a bunch about equity financings, and then go kick some convertible note ass.