Some Seed Funds and entrepreneurs like to use convertible notes, which pegs the valuation of the seed investment to that of the first round (which is typically expected to happen a few months down the line). In response to an earlier post by Brad Feld on “What’s The Best Structure For A Pre-VC Investment?”, Josh Kopelman, Managing Director of First Round Capital, explains why he has a strong preference for Preferred Equity versus Convertible Notes.
A typical convertible note allows an investor to convert from debt into equity at some discount to the Series A price (typically 20-40%). I believe that this often has an unanticipated outcome — it puts the seed-stage investor and entrepreneur on different sides of the table. The entrepreneur wants the Series A price to be as high as possible, while the note holder wants the Series A price to be as low as possible (since the conversion price of their note will be based on the Series A price). This misalignment of interest creates a number of problems for me. Once I invest in a company, I would like to focus on adding as much value as possible – I want to help the company refine their strategy and business model. I want to help them build their team. I want to introduce them to business development partners. I want to help them generate PR. I want to introduce them to several VCs so they can raise their next round on good terms. However, as a note holder, there is an economic penalty for adding value — the more I try to help the company, the more expensive my equity ultimately becomes. In effect, I have to pay for any value I help create. If I was an equity holder, those conflicts would not exist. I would benefit directly from any value I help create.
Arun Natarajan is the Founder of Venture Intelligence India, which tracks venture capital activity in India and Indian-founded companies worldwide. View sample issues of Venture Intelligence India newsletters and reports.
