Nice write-up with a good explanation of the main features of convertible notes.
With such notes, the startup and its investors essentially kick the valuation question down the road. In an environment where subsequent fundings are highly likely for quality companies, they can work fine; in today's dicier environment, much less so.
One point about the author's cost/benefit comparison of legal fees for doing notes as opposed to doing a straight Series A funding. If the angels are friendly and do not push too hard to try to convert the Series A into a VC-style round, the processing costs of doing the preferred-stock approach can be as little as $5K. It is only the angel groups that function almost like VCs that require the sort of complex transactional documents that will run costs up to $25K+.
The potential for low-cost Series A docs, of course, is one more reason in today's environment to go ahead and price the stock and do a Series A in lieu of kicking the can down the road.
Of course, pricing has its own issues because this can take away flexibility in how a board will price options as incentives for key people and will also typically require the startup to do 409A compliance earlier in connection with its options pricing (which in turn may add $5K to $10K to immediate costs).
Grellas, have you seen many deals involving convertible notes with fixed or capped valuations? Care to comment on these? They don't, by definition, "kick the valuation question down the road".
Convertible notes are very company-friendly and institutional angels will use valuation caps to balance the risk more in their favor. Since the caps are really best guesses of what future valuation might be, they don't affect stock pricing for the company going forward (a reasonable explanation of how they work can be found here: http://www.spartina.com/items/20685-convertible-note-cap) and so the valuation question actually does get deferred in a legal sense.
In the deals we do, I tell founders to avoid using caps and they tend not to be used since they create complications for the downstream funding by working to give unduly steep discounts from actual Series A valuation in some cases.
Surprisingly, however, the issue usually doesn't even come up in most cases because it is the institutional angels who will tend to insist on caps and my clients normally avoid such angels, preferring instead to work with the "successful entrepreneur" wealthy individual type of angel (who will either be fine with using convertible notes without caps or, if he insists on putting a value on the investment, will just push for a straight Series A investment - again, if done on "friendly" terms, which these easily can be in such cases, the cost associated with the investment might be $5K or so, thereby not constituting any serious drain on, say, what is typically a $200K investment or so).
Stay the hell away from angel groups. Only deal with individual angels investors.
Angel groups almost universally consist of large numbers small time "investors" who don't really have the net worth to invest on their own. They take months and months to make a decision, and will invest a smaller amount, at a lower valuation than any individual angel.
I've yet to meet a single serious angel investor who's had anything positive to say about angel groups.
With such notes, the startup and its investors essentially kick the valuation question down the road. In an environment where subsequent fundings are highly likely for quality companies, they can work fine; in today's dicier environment, much less so.
One point about the author's cost/benefit comparison of legal fees for doing notes as opposed to doing a straight Series A funding. If the angels are friendly and do not push too hard to try to convert the Series A into a VC-style round, the processing costs of doing the preferred-stock approach can be as little as $5K. It is only the angel groups that function almost like VCs that require the sort of complex transactional documents that will run costs up to $25K+.
The potential for low-cost Series A docs, of course, is one more reason in today's environment to go ahead and price the stock and do a Series A in lieu of kicking the can down the road.
Of course, pricing has its own issues because this can take away flexibility in how a board will price options as incentives for key people and will also typically require the startup to do 409A compliance earlier in connection with its options pricing (which in turn may add $5K to $10K to immediate costs).