When I was a kid, there were a series of memorable commercials from a company called Fram which made automobile oil filters. The message behind all of their commercials was that you could pay $4 for a quality oil filter today or pay hundreds or more to fix your engine later. If you’re over 45 you’re smiling now. If younger, here’s an example:
These commercials come to mind as I’m witnessing the effects of the proliferation of capped convertible note seed rounds. Mark Suster, Brad Feld, Duncan Davidson and others have written insightful pieces lately about the downstream challenges these notes are causing entrepreneurs when it comes to raising subsequent capital. Click on their names above to read them.
When I started in the venture business, you rarely if ever saw a convertible note. Today, it’s the priced seed round that’s rare. There’s no doubt that a convertible note makes life easier for a founder when raising a seed round. First, most founders believe their seed-stage startup is worth more than they could fetch in a negotiated priced round and the capped or (god-forbid) uncapped note is a great vehicle which allows an entrepreneur to grow their company into a higher valuation. Second, it allows them to delay what they perceive to be an uncomfortable valuation discussion. Solution? Throw a cap on a note and kick the can down the road.
Sadly, I’m watching this strategy come back to haunt so many founders going out to raise their seed extension or Series A rounds because of the inflated post-money valuations their companies are now sitting at as a result of their capped notes. Most entrepreneurs I know haven’t taken the time to fully understand the implications of these notes. Even at Techstars where we teach our founders about this, I still see mostly capped-note seed rounds. I get it. It’s easier.
My advice? Price your seed rounds. It was done for decades and it worked. It leaves no ambiguity and all the investors know exactly where they stand. Most importantly you’ll have no cap table issues when it comes time to raise your next round of capital. Is it a little more work to get this done? Yup, but tell me anything worthwhile that doesn’t cause some discomfort. Most founders I know don’t take the easy route when building their products because they know there’s negative downstream effects of that strategy. Why do it when raising capital?
What’s the cost of doing a priced seed round? Well, you’ll have to find an investor who will A) be willing to price your round (usually your largest investor) and B) you might not get the valuation you were hoping for. The former shouldn’t really be all that difficult and there’s reams of great posts out there supporting that the latter is irrelevant if you build an important, long-lasting company. So like the Fram commercial says, you can pay now, or you can pay later…