“Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”
It garnered so much attention in the VC world because the value of convertible debt versus traditional financing rounds is controversial.
In fact, there’s even disagreement as to what kind of convertible debt–capped or uncapped– is best for investors and entrepreneurs.
Here’s the deal:
- A convertible debt is a type of financing that has three distinct characteristics: It doesn’t give the investor any legal authority in the company, thereby reducing legal fees associated with the investment (from near $40k to just $5k), and it defers valuation to the next round. In return for the risk the investors incur, they are offered a significantly upgraded rate when investing in future rounds of financing.
- A capped convertible debt essentially sets boundaries for that significantly upgraded rate, while still avoiding negotiations on an (often premature) evaluation of the seed or early-stage company. That cap helps avoid the conflicts of interests that arise between a VC and a company in the eventual valuation of a company.
- Meanwhile standard equity financing sets strict parameters on the companies valuation, gives investors legal sway with the direction of the company, and has legal fees that can reach $40k.
Obviously, Paul Graham is happy to see that entrepreneurs and investors are increasingly agreeing upon convertible debt structures. Chris Dixon, an investor in early-stage companies, also likes this trend. Albeit, with the caveat that the convertible debt financing is capped. He argues that although investors don’t get as much legal power, he believes it builds a level of trust between VCs and entrepreneurs that’s crucial to the success of companies.
Meanwhile venture capital investors Seth Levine, Mark Suster, and Fred Wilson, aren’t so hot on this trend. All three note the symbiotic relationship between investors and entrepreneurs. Investors aren’t trying to fleece entrepreneurs, and entrepreneurs are dependent upon those same investors for financing and expertise.
Essentially, they believe the growing popularity of convertible notes is overly favourable towards entrepreneurs and therefore throws off the delicate balance between VCs and startups. That, they fear, jeopardizes a market that’s currently flush with venture capital dollars.
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