I’ve noticed some interesting posts on the subject by Brad Feld, Josh Kopelman, Jeff Clavier, Dick Costolo, and Education Revolution, among others. In addition, there seemed to be a lot commentary (such as from Fred Wilson) about Charles River Ventures QuickStart Program that involves a seed financing with a convertible note with an increasing (but capped) discount over time.

Generally speaking, I think that the founders of a startup company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A, the valuation is probably going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People good at excel should try to model the different scenarios.  Venture Hacks has a good article about the math involved in this modeling exercise.

2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A. However, this is not always the case.

That being said, I think that there are two principal reasons to dislike convertible debt from the founders’ perspective.

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A to be low, so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.

2.  Investors may request aggressive terms.  For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc.  In a Series A financing, there seem to be some established norms on what is typical.  In a convertible note bridge financing, creative investors may suggest some unusual terms.

I will run through the nuts and bolts of a sample convertible note bridge financing term sheet in the next series of posts.