Bad Notes on Venture Capital

By Mark Suster

This week. On the phone …

Me: So, you raised venture capital?
Him: Yeah. We raised a seed round. About $1 million.
Me: At what price?
Him: It wasn’t priced. We raised a convertible note.
Me: With a cap?
Him: Yes, $8 million.
Me: Ah. I see. So you did raise with a price. It’s just a maximum price. You’ll find out the minimum when the next round is raised.
Him: Huh?

Last week. At an accelerator …

Me: Raising convertible notes as a seed round is one of the biggest disservices our industry has done to entrepreneurs since 2001-2003 when there were “full ratchets” and “multiple liquidation preferences” – the most hostile terms anybody found in term sheets 10 years ago. Convertible notes have both features in them but for some reason entrepreneurs don’t understand it. It’s like we need a finance 101 course for entrepreneurs
Him: But when I raised my first round we didn’t know how to price the company. There were no metrics. So a convertible note was easier.
Me: Ok. Well. How will you price the next round? Your A round?
Him: On metrics. We’ll have some proof points by then.
Me: Cool. What proof points? How will the lead determine a value? Revenue multiple? EBITDA multiple? Cashflow projections?
Him: Um. I’m not sure.
Me: There is no rational explanation for valuations of A round companies by ANY objective financial measure. It’s simply what a market is willing to pay based on a future belief that your company will grow and non-linear rates and be worth much more in the future. In finance they call it “terminal value” but the truth is the price is as arbitrary at your A round as it is at your seed round. If we priced it based on any metrics your company would likely be worth less than 7 figures at your A round. Objectively.
Him: But it’s much cheaper to just use the Series Seed term sheets that every law firm has put out so convertible notes make more sense because they’re cheaper and easier.
Me: Then why don’t you take that same Series Seed doc and stick a price in it. That way you don’t have a max or min price but you have a price
Him: But then what if people don’t want to pay that price?
Me: When an investor signs a note with a cap they must assume they are willing to pay the cap or why would they invest? Either that or they’re dumb. Plus, if you price it then when you go to your next round of financing there is no haggling with future investors on what the note should be priced at. The price is simply the price

Last year …

Me: So why did you choose a convertible note?
Him: We didn’t want to price our round
Me: Did you have a cap?
Him: No. Just a discount to the next round
Me: So, who was willing to invest in that? Was it friends and family? I can’t imagine any rational investor would sign up to that.
Him: Yes. Mostly former colleagues and friends.
Me: Ah. I see. So they backed you – a person they trust. A friend. If you’re wildly successful early on or if they help you achieve a great valuation they actually pay a significant price for their eventual stock even though they took much more risk than a future investor and backed you early. How do you think they’ll feel if your next round is at a $50 million post money valuation and their hard-earned $25,000 is worth 0.05% of your company? Less than you’ll probably grant your most junior employees in stock options?
Him: Not so good. Obviously he’d be pissed off. I hadn’t really thought about it.
Me: I know. You and everybody else.

Last year …

Me: So you raised a convertible note? What was the cap?
Him: $12 pre. We raised $2 million.
Me: How are your negotiations with VCs going?
Him: A bit tough. People seem concerned about valuation
Me: Why do you think that is?
Him: They think $14 post is a bit too high
Me: But I thought you told me it was a convertible note? Doesn’t their investment determine the price of the next round? Isn’t $12 pre just a maximum?
Him: Yeah. But people seem pretty focused on that number. Raising lower seems kind of like something is wrong. And now I have to explain to team that they’re taking more dilution than they expected if we do a down round
Me: More dilution? A down round? I thought it was a convertible note with a cap? Didn’t you consider that raising at $8 million was a possibility?
Him: Um. We never thought about it.
Me. Huh.

Tonight. At dinner …

My colleague: We have a bit of a problem. They raised multiple seed rounds and each at different prices with convertible notes. They raised $2 million but when you add up all of the liquidation preferences if they convert at our proposed share price the total liquidation preferences would equal more than $7 million
Me: Yup. I see that all the time. I know how to structure around that to protect the founders from getting screwed on a multiple liquidation preference. But most VCs don’t bother so many convertible note founders get screwed and never know it until they sell their companies.
My colleague: Whoa.
Me: Yup. The whole industry has strangely accepted this artificial structure for all the wrong reasons. There are a million ways to do quick, easy, low-cost rounds with prices. There are a bunch of ways to offer cheaper pricing to people who commit early without notes. But founders these days seem strangely unfocused on finance and on terms that could hurt them even though we fought to the death about these same terms 10 years ago

The scoop.

These are all real conversations. I have them all the time. I’m bored of it. 99.9% of the time I have no vested interest in having the debate. I’m just trying to be helpful because in this case more than any I truly understand the structure from both sides of the table. People keep taking the sucker’s bet and I can’t talk them out of it.

Here’s some more details on Convertible Notes if you’re interested.

I have never come across a sophisticated A, B or C round venture capitalist who thinks convertible notes are a smart move for entrepreneur or investor. They only people I have heard promoting them tend to be super early stage investors or accelerators and often when I talk to them about the structure they’ve never given much thought beyond “they’re easier,” “they’re cheaper” or “it’s faster to raise this way” none of which is actually true.

I’ve heard: “Well it’s great because you don’t have to agree terms with your investors. You can negotiate that later!’

But do you want to start a relationship with your most important supplier – that of capital to fuel your business – by avoiding talking about his or her expectations in terms of rights or privileges? What if when you have that conversation you don’t agree? It’s like punting on discussing with your future husband or wife what religion you’re going to raise the kids. If it’s important to you wouldn’t you discuss it up front?

“But how do I offer cheaper prices to early investors?” Simple. If you want to give them a 50% discount offer them $1 of common-stock warrants (no liquidation preference) for every $1 of stock they buy. If you want to give them a 33% discount you offer them half of a $1 common-stock warrant for every $1 share they purchase. And so forth.

“But lawyers will charge much more for equity.” Not in my experience. Lawyers don’t make money on your seed round in any instance. They are investing in your relationship in hopes that you do an A, B and C round. A few M&A transactions. IP. Employment. Stock Option plans. Maybe an IPO – who knows?

Well … the reason I want to do notes is so I can do multiple closings. Try doing THAT with equity. Um, ok. How about you close your first capital (say $500,000) and put in the docs that you have up to [90] days to raise an additional $1 million at the same price at your discretion.


I actually use this method on at least 50% of the deals I close. I often will fund 80+% of a round and move quickly. I give the entrepreneurs usually 30-60 days afterwards to top-up a round with other helpful angels or seed funds that we mutually agree. That way neither of us have to wait for stragglers and the entrepreneur can be picky about whom they let in because they don’t feel pressured to get answers quickly.

[Update: From Twitter a commenter says, “One of the advantages of notes is that you don’t have to have a lead.” – and other lies first-time founders tell themselves. No lead equals nobody owns responsibility for you if things aren’t going well. You WANT a lead. Could be a VC seed lead, a VC lead an angel lead. But in life investors are looking for somebody inside the tent to tell them what to do if you need more money. It’s like the Pottery Barn rule, ‘If you break it you fix it’ as in … If I’m the lead and I help round up other investors and things hit a pothole everybody knows I own helping the founder through it. This is why Party Rounds in VC suck.”

Ok. Truthfully. I don’t have some big dog in this fight. I really just want to champion Finance 101 to entrepreneurs. I just simply want to help you to avoid signing a silly deal if I can get through to you.

But wait. Is there ever a situation where a convertible note is a good idea?

Yes! Thanks for asking.

Convertible notes were previously used primarily for “inside rounds” in which the existing investors provide you with bridge financing to get to the next round.

Why don’t they set a valuation then?

Well. For starters – you and they both don’t necessarily want to set a price because you’re hoping a future investor will pay a higher price for the next round given progress has been made. If you set a price now then that will be used as a benchmark for the next investor to justify a lower price.

But why would my investor do that? Isn’t it like you said about angels? They are paying now to increase price and they will convert later at a higher price? Isn’t that conflicting advice?

Well. Actually not. Because they are existing investors. Here’s a couple of reasons why.

1. They already locked in stock at a lower price. So if the next round is higher they have a much lower cost of ownership than the next investors anyways

2. They would likely have had to participate prorata or some portion of it in the next round financing anyways and at the price that the next round investor chooses. So it’s less of a big deal if you’re an insider

3. The higher their next round the more they can “mark up” their initial investment which is usually a multiple higher than the bridge so if they achieve a higher price later it’s win-win for them.

4. Often since they’re insiders they don’t have a choice other than to shut the company down or to use the fact that you’re out of money as leverage against you. That does happen. But most VCs prefer not to do that as it’s self defeating.

I hope these notes helped a bit. Even though I know most of you will succumb to the industry pressure and just do convertible notes anyways


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