Convertible note confusion

ONE OF THE MORE CHALLENGING THINGS a new entrepreneur must deal with is fundraising. It is a time consuming distraction from business operations that is made more difficult by the challenge of setting a realistic company valuation and the expense of complex funding documents.

This reality has led many to try and use convertible notes instead of stock in their early funding rounds. But using convertible note to raise funds presents its own challenges as I was recently reminded by two separate entrepreneurs at Georgia Tech.

First, there is the question of whether you use a convertible note or a SAFE (simple agreement for future equity) document of the sort developed at the Y combinator. The advantage of a SAFE document, when investors will use it, is that it gets rid of the fiction that the seed stage company using it will be in a position to repay the money if it does not raise needed funds in a next financing. Instead, if a fundraising does not occur, the holder of the instrument converts to equity at a predetermined formula.

Whether it is a SAFE document or a convertible note, several questions remain about how it should be structured. A partial list would include:

• What discount is applied to the anticipated 'venture' funding when the instrument converts into the stock acquired in that funding? Does 20% make sense? Or, is that too high? It probably depends on where you are and what you anticipate accomplishing with the interim funding.
  
• What happens if the anticipated future funding is delayed? Or worse, what if it does not happen or only a partial funding occurs? Does the instrument convert? And, what does it convert into?
  
• What if the next financing is at a higher valuation than anticipated? Is there a cap on the valuation for conversion purposes or should the SAFE/note investor be happy with the negotiated discount? If there is a cap, what should it be? If there is a cap, should there also be a floor?  
  

It is always worth getting more than one opinion when you are approaching an early stage fundraising. Even if you have an experienced lawyer and accountant, Their counsel may not fit perfectly with your situation or objectives.

Photo of the 'post office' on the Galapagos Islands. Copyright 2008 by Clinton Richardson.