Originally published as a trial over on Medium...
Another of Josh Cook’s posts that got me thinking was Convertible Notes will be the death of us all. The issues that Josh calls out are definitely ones that I’ve run into, the confusion over how the notes convert and what the hell a cap actually means are the most common issues I’ve run into with convertible notes. I've been thinking a lot about this and have been reviewing the new YC SAFE concept as well as the concept of convertible equity to see if there are any better alternatives for investors and founders. Ultimately the goals should be aligned for the investment to be a good one and at times this can be problematic as I mentioned before. Regardless of the investment vehicle, convertible debt, convertible equity, SAFE, warrants, revenue based financing, common stock, etc. the investors and the founders are really boiling down their negotiation down to a few key terms that are embodied in any of the vehicles. The motivation behind the terms on the founder and investor side depend heavily on whether the investor is coming in as just the money or if they are coming in as money and partnership.
- What percentage of the company is being exchanged
- What is the timeline for the ownership and investments
- What value will the investors add to the company
- What control is being exchanged
- How will this investment be treated in relation to the next investment
- How much capital is being invested in relation to all of the above
There aren't many more terms than these and thinking through all of the vehicles, there does not appear to truly be one that is inherently more favorable to founders or more favorable to investors. Paul Graham will say the new YC SAFE vehicle is the best (then again he said that about their convertible note). The reason he is saying that though is because of the terms in the SAFE agreement - a convertible note could have similar terms and be just as easy to use. The problem is that the terms inside of these vehicles are difficult to interpret for founders and early stage investors (unless the investor happens to be a lawyer). This is why so much content has flooded the internet trying to explain what the hell a convertible note is, what a cap is, what valuation truly means for a company, and if any of these things actually matter. At the end of the day, the six points above are really all that matter. I suggest you start with those six things and agree in principle on those before you worry about the next step. Some people like to use the same vehicle every time as it reduces the overhead of getting up to speed and drafting something brand new. You should still agree on the six terms ahead of opening your vehicle of choice and filling in the blanks.