In the last few months in working with financings, I have gotten to know the Convertible Notes versus Preferred Equity issue very well. As an angel investor, I am constantly thinking about maximizing my money and I don't have the cash to play the field in a broad, diversified way to not care about this issue like some larger angels. Thus, knowing when to take a deal or walk away is part of the game, and certainly financing terms are part of that decision.
Again, I reference Josh Kopelman's post on Notes and Preferred Equity and think it explains many details well. I'll talk about this topic with his thoughts and some of my own in mind.
Why would I be OK with a Note?
The terms must be good.
Often Notes have no anti-dilution provisions or special provisions that help us in case the next equity financing does not occur. They seem to be hastily drawn up and many details are left out. I have walked away from Notes that didn't have enough good terms in there.
They are mostly unsecured, so I'm OK with that. I know that I'm dealing with an early stage startup and they have little or no assets at this point. What would I do with 1/10th of a PC?
I also want to make sure I am not locked into a particular Next Equity Financing by default. I want to have the ability to back out if company conditions change.
If they require an auto-conversion provision in their to the Next Equity Financing, then I want them to insert a minimum on the money raised, to ensure that they don't do something screwy.
In truth, I don't pay much attention to the interest rate return for early stage startups. This is usually a make or break time for them. If they don't get the Next Equity Financing, then often the company will tank and I won't get any interest payment or my money back yet. I do just make sure it is in range of other Notes I've seen which is about 6-8% per annum.
There is a Preferred Series financing imminent.
Most Notes are used to gain cash to continue company operations just prior to a first Preferred Series financing. My goal is to always get share of a Preferred Series. If I know there is one coming soon, then I'm OK with a Note knowing that I'll convert in a few months. Time is minimized between the Note and the Preferred Series and there is a less of a chance that the company valuation will change dramatically, causing loss in ownership share from when I invested and when it converts.
Why would I NOT be OK with a Note?
There is no Preferred Series in sight, or I am not confident it will happen soon.
If the Note is being raised, but they have nebulous plans for raising the next Preferred Series. I won't do it. The risk of it dragging on for a long time is there, and the more time that drags on before I gain actual ownership in the company, the more chance that it goes not in my favor. The valuation could go up (meaning I convert to less ownership than I originally thought), the company could go under with not enough funds, or I mayjust get paid back and not reap any benefits of having ownership in the company, if the company starts gaining revenue. The company need not be going under for you to not gain the benefits of investing in a company.
Or they may SAY they are going for Preferred Equity fund raising, but I get the feeling they will drag their heels or avoid seriously doing it. As soon as I get some intuition that this is true, I won't do it.
This is a second (or beyond) Note they are raising.
This begs many questions. Is the company trying to be greedy and not give up any ownership? If so, they can build their company on other people's money then. I want to maximize return and getting interest rate return on my money is not the way to go.
Or you have to wonder why this is yet another Note. Why do they need another Note? Why haven't they raised their Series A? Or what is wrong with them that they can't raise their Series A? Many Notes are written vaguely that the Note will convert to Next Equity Financing. They may actually want to convert the last Note holders to the terms of the second Note which may be less favorable to them!
Although this may seem like a given, it could mean that the company opportunity is really good, but the Note terms are not.
Terms always take care of the worst case scenario and nobody wants to see them come into action. But sometimes, the terms are there and you can't change them. I've already had a case where I wanted to change the terms but the entrepreneur did not because the current terms were already approved by the lead investor, and he did not want to scare the lead investor off. But, it was obvious that the lead investor didn't really read the term sheet carefully because some of those terms were bad even for him.
By the way, I think this happens frequently in the Valley. There are so many large investors that when they invest, it is a small amount for them but large enough to make them lead investor. But they go through so many deals that they don't seem to be spending time on the terms at all. I've heard from one person that they just write off investments that get diluted to nothing or fail, and employ diversified investing across many different investments and hope that a few make it big to cover the many that return little. Very frustrating for us smaller angel investors.
Always be ready to walk away no matter how good parts of the deal looks...
Investors are not aligned with interests of the company in building value.
Clearly stated in Josh Kopelman's post, it makes sense that as investor I want the valuation kept as low as possible so that I convert to as high ownership as possible. But my model is to help entrepreneurs as much as possible. So if I end up helping them and sign up as advisor, but feel that a Note they may be presenting may not be in my best interests, I may end up not investing at all.
Why I like Preferred Series.
I have ownership in the company.
I gain immediate ownership in the company and this point is not nebulous, as in the situation of the Note.
Generally, preferred terms are pretty favorable to me.
There will be provisions for voting, company control, preference in paying back, potential dividends, etc.
I am aligned with the interests of the company.
Once I have ownership in the company, I can freely and without reservation help the company build value, as my own value in the company will also grow.
Why not Preferred Equity?
Not many reasons to not jump into an investment if Preferred Equity is offered, assuming all other factors are positive.
Sometimes, there is a gotcha in the terms.
Potentially the terms could be not quite right. This happened once where the voting rights were not favorable to the Preferred Series Angel round. I caught this at the eleventh hour and thankfully the entrepreneur agreed to a change in the docs to make this more favorable. Otherwise, our terms and rights could have been wiped out without us having any say in it! You always need to review the terms no matter what and I would do it with a seasoned lawyer who has done many financings before, and hopefully from the perspective of company and investor.
Caveat Emptor - "Let the Buyer Beware" - words to live by and in the investing world you have to dig into every little detail in every deal. It costs more in time and money, but it keeps me out of trouble.