Convertible notes and SAFE’s are impacting startups’ ability to raise a Series A. While these convertible securities have the advantage of being low cost from a legal standpoint and fast to execute, avoid allowing any more than $500k of convertible securities to be outstanding going into the Series A, otherwise it will impact your ability to raise the next round.
The problem with convertibles is that they: i) dilute the Series A investor exponentially; and ii) dramatically increase the size of the preference stack for the Series A investor. Anything that negatively impacts the Series A investor will obviously make it harder for you to raise a Series A, which is already the hardest round to raise in this environment. An example below will help show how detrimental these securities can be.
|Scenario A||Scenario B||Scenario C||Scenario D|
|1||Shares Before Round||1,000,000||1,000,000||1,000,000||1,000,000|
|2||Size of Series A||$3,000,000||$3,000,000||$3,000,000||$3,000,000|
|3||Share Price for Series A||$12.50||$12.50||$12.50||$12.50|
|3||Share Price for Notes||$10.00||$10.00||$10.00||$10.00|
|4||New Series A Shares||240,000||240,000||240,000||240,000|
|4||New Shares for Notes||50,000||100,000||200,000||300,000|
|5||Post Money Valuation W/O Notes||$15,500,000||$15,500,000||$15,500,000||$15,500,000|
|5||Dilution of Note||$625,000||$1,250,000||$2,500,000||$3,750,000|
|5||Post Money Valuation with Notes||$16,125,000||$16,750,000||$18,000,000||$19,250,000|
|6||Preference Stack w/o Notes||$3,000,000||$3,000,000||$3,000,000||$3,000,000|
|6||Preferene Stack with Notes||$3,500,000||$4,000,000||$5,000,000||$6,000,000|
1. In our example, we assume our company has 1mm shares outstanding. Not included in the share count is the last round which in this case was a convertible note with a 20% discount, $10mm cap, and no interest to keep things simple. In the above example, we show 4 different columns that represent 4 scenarios in which we have a different level of note outstanding ($500k, $1mm, $2mm, $3mm). These amounts coincide with what DAN Fund tends to see most often in the market.
2. Our company has grown nicely to $100k of MRR, but we’re still burning $70k a month and want to scale, so we need to raise a Series A. In our example, we want to raise a $3mm Series A at a $12.5mm pre-money valuation.
3. Given that we have 1mm shares outstanding, the price per share at a $12.5mm pre-money will be $12.50 for the Series A investor ($12.5mm valuation/1mm shares). For the convertible note holder, the price per share will be $10.00 ($10mm valuation/1mm shares): Recall that the terms of the note are $10mm cap or a 20% discount, so since the pricing of the Series A was $12.5mm, in this case the notes will convert at $10mm which conveniently happens to be the same number whether you use the cap or the discount ($12.5mm * (1-20%) = $10mm; we did this to keep the example simple).
4. At these prices, this will result in 240,000 new Series A shares being issued to the Series A investor ($3mm investment/$12.50 per share) and anywhere from 50,000 Series A shares to 300,000 Series A shares being issued to the note holders.
5. This brings us to our first major problem with convertible notes: dilution. If the note holders had not invested in a note, but instead invested in common stock or seed preferred, there would be no dilution to the Series A investor and the post-money valuation would be a clean $15.5mm in every scenario ($12.5mm pre + $3mm of fresh money). However since there are notes we have to account for, the Series A investor suffers anywhere from a mild 4% dilution to an unacceptable 24% dilution. In practice, what DAN Fund and many other VC will do to avoid the dilution is require the convertible notes to convert before the Series A round is consummated. This ends up taking time as the founder then has to go get approval from the noteholders. If you can’t get noteholder approval, we then have to invest at an artificially low pre-money valuation to offset the dilution of the notes. This ends up shifting the dilution onto the founders and anyone else that owns common stock (friends & family) which is obviously the least desirable outcome for you and the Series A.
6. The next major problem caused by the notes is the size of the preference stack. Series A investors care about seniority and being the first in line to receive capital should things go poorly. It is highly undesirable to share that preference with any prior investors, but if there’s note outstanding, that note becomes part of the stack and as you can see in the example, the difference is anywhere from 17% to 100%, all of which are very difficult to swallow. In practice, DAN Fund or other VC may require the notes to agree to convert into a junior preferred Series A whereas the we would get senior preferred, so we preserve our spot at the top of the stack. Again, this will require approval of the note holders and will put the noteholders in an adverse position to the Series A investor.
Many VC will avoid deals that have too much note all together ($500k+). They have plenty of deals to look at so why should they put themselves through the headache of dealing with convertible note or SAFE holders that are going to dilute them? We very much encourage founders to avoid any type of convertible security over $500k, and instead have investors invest in common stock, seed preferred, or any other security that does not make it harder to raise the next round of capital. In this environment, seed capital is arguably the easiest to raise and Series A is the hardest, so don’t do anything in the seed round that will make it even more challenging to get the Series A done.