Revenge of the Convertible Note
Founders are clueless and investors are full of themselves. There, I said it.
Founders
Founders shuffle in from the startup house — slash — dispensary with a mix of unearned bravado, focused passion for what’s truly important, and a dozen or more extraordinary personality traits you just can’t teach.
Forget the wannabes asking “how can I find investors for my great idea?” You can’t orchestrate a startup playing air guitar. The real rock stars — even those who can’t play the the game yet — will be the ones to launch the next iPhone or ChatGPT.
Their fundraising axe? The SAFE, a brilliant document recently invented by Y Combinator to divest investors of every conceivable right while going down easy as Sunday Morning. It doesn’t even include a secured ownership interest in the company. The acronym, I believe, stands for Shutup About the Fuckin’ Equity.
Investors
Meanwhile, angel investors descend from the country club chanting my money, my rules. Intuitively appealing, but financial garbage.
Their weapon of choice? Priced equity rounds. The structure, a Series Seed Convertible Preferred Stock Purchase Agreement (for which there is no good acronym, SSCPSPA??) with a dozen supporting documents hanging off the side. It’s an old war beast full of promises that a startup cannot keep and representations no founder could make. A totally unrealistic structure for brand new startup companies.
Random case in point, the GAAP accounting obligation. Have you ever tried to do GAAP accounting on a seed stage startup? I have, it’s not pretty and it won’t work.
Investors need a 99.9th percentile founder willing to accept their money, not a doofus they can browbeat into doing what they say. Onerous offers optimize for getting a 50% better return out of dupes, desperados, and real estate trusts. Not great for landing the next Tesla, Facebook, or OpenAI, the kind of unicorn you need in your portfolio to balance the 9 out of 10 investments in even in the saviest investor portfolios that fail or barely break even.
Why don’t you meet me in the middle?
The real challenge isn’t to design the best structure and lawyer the strongest agreement for either founders or investors. It’s finding a middle ground that works for both stubborn investors and headstrong founders. When there’s daylight between the two you can balance the deal with a higher or lower price, not dysfunctional terms.
Founders had the upper hand in the heady times between the end of the Great Recession in 2012 until the pandemic recovery and consequent Great Reset of early 2022 when interest rates rose and the bottom fell out of the startup economy. Even today, founder-friendly SAFEs represent 75 to 80% of all pre-seed startup funding deals, including the very best ones. Investors are pushing back, and some outright refuse anything short of a priced equity round — to their detriment, I think.
The National Venture Capital Association has long proffered model documents for priced rounds, updated most recently in April 2024. These take a step or two towards balance but remain a cumbersome grab bag of investor wishes best suited for active professional investors leading larger, later funding rounds.
A group I work with, Gust Launch, has published its own take on the NVCA documents, the Gust Series Seed, going a couple steps farther to simplify and fill in the blanks with more balanced founder-investor terms. It’s a good starting point, with the added benefit that standardized documents set achievable expectations, cut legal costs, and encourage transparency in negotiation.
Convertible Notes
Enter the Angel Capital Association, which reportedly plans to introduce a new model convertible note in coming days.
Convertible notes, a form of debt that converts to preferred stock at a company’s next institutional financing, were the prevailing quick-and-easy investment structure from the mid 90s until SAFEs replaced them in the mid 2010s.
Some investors who disdain SAFEs are okay with convertible notes, possibly because the debt they hold prior to conversion gives them a cudgel to beat errant founders over the head with should they go astray. Personally, I believe that anything an angel investor wants or needs in a convertible note or a priced round can be done easily in a well-drafted side letter.
I’m a little skeptical that a new model document designed by committees of investors will produce realistic terms and avoid onerous demands, but we’ll see. I’ll review it with an open mind when it comes out, and plan to write Part II of this series once I do.