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The Case Against Convertible Notes: Part 3

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Matt Dunbar
Last updated: June 4, 2024
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If you missed our prior posts in this series on The Case Against Convertible Notes, click to read Part 1 and Part 2 about the downsides for founders and investors. In this third and final post, we’ll reveal some of the hidden costs of convertible notes that are rarely discovered until the conversion event is imminent.

Anti-dilution triggers

Let’s suppose a founder raises a Seed round at $1.00 per share, then later raises a “bridge note” with a 20% conversion discount. Then let’s suppose the company raises a Series A round at $1.10 per share, so the conversion price on the note will be $0.88 ($1.10 x 80%).  Of course, this conversion price is below the price of the Seed round, so assuming that the Seed round carried a weighted-average anti-dilution provision (like most of them do), the Series A round has now triggered the anti-dilution clause for the Seed round. That essentially means those Seed round investors will get credit for more shares than they bought when it is time to exit, further diluting the founders. For more detail on how the math works for anti-dilution triggers (and other scenarios), check out our workshop on Understanding Cap Tables.  

Legal expenses

Once a company starts dealing with the complexities and conditions associated with converting notes and handling potential anti-dilution clauses, it begins to rack up more time on the clock with legal counsel who now has to work out the math and confirm all the complicated details.  This of course starts to add up in billable time - and we have seen more than one case where the lawyers actually got the math wrong - which is an even bigger risk.  So in general, founders are better off avoiding complexity, uncertainty and confusion around who owns what - which will save time and money and stress when it comes to the legal work involved in the next funding round. 

Minimum thresholds

Remember that convertible notes typically involve a minimum threshold for raising the next round, so if founders set that bar moderately high and things don’t take off like the rocket ship they envisioned, the company may have a hard time raising enough money to meet the minimum threshold. In that case, noteholders might decide to hold out rather than waiving the minimum to convert (remember the misalignment we discussed in Part 1), and since the new equity investors are highly unlikely to invest if there would still be unconverted notes outstanding after the round closes - the entire round could be sabotaged.

Stacked notes

We’ve seen a disturbing trend in which founders will not only raise an initial convertible note - but then they will stack additional notes on top of the first one before raising an equity round. We’ve seen up to four (!) consecutive stacked notes with different terms - which makes it very difficult to get a new equity round structured given the aforementioned complications and the substantial additional dilution that must be taken into account from the interest and discounts on the multiple notes.  Depending on the terms, this cascade of circularities and complexities will drastically lower the chances of securing a new equity round - or significantly increase the time, cost and stress of completing one.

A note on SAFEs

Of course, others have recognized many of these challenges stemming from convertible notes. In response, several years ago, Y-combinator introduced a novel new structure designed to circumvent some of the key issues stemming from the interest provisions of convertible notes. The Simple Agreement for Future Equity (SAFE) is essentially a convertible note without the interest, which eliminates some of the problems highlighted in our series.  While the SAFE structure is a partially helpful step in the right direction, it still does not address the more fundamental problems with convertible notes (namely, a lack of clarity and agreement on valuation and ownership, which leads to misalignment, uncertainty and potential future cost, complexity and contentiousness). So, not surprisingly, we view SAFEs in the same bucket as convertible notes - a problematic structure only appropriate for very limited situations. 

We certainly haven’t covered every wrinkle or nuance about convertible notes in this series, but we hope we’ve provided some insight on the hidden and not-so-hidden disadvantages they carry. 

If you would like to learn more about the impact of convertible notes - and equity rounds - on your capital structure, we invite you to sign up for one of our upcoming workshops on Understanding Cap Tables.  In the workshop, we dive much deeper into various scenarios and structures for convertible notes and equity rounds using a case study approach. We also provide templates you can use as a starting point to build your own cap table model for scenario analysis and capital planning. We run these workshops regularly.

We welcome your comments, feedback, suggestions and corrections on our Case Against Convertible Notes series.  Thanks for reading and best of luck in your fundraising and/or investing!