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Comment by rahooligan | Hacker News Reader

according to this the main problem with notes is a down round can get you into a lot of trouble because of the liquidation preference multiplier. but what if you never have a down round? if you can avoid the down round, it seems like convertible notes are still preferable. down rounds are bad even with priced seed rounds.

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The liquidation preference multiplier has to do with when noteholder gets preferred only instead of preferred + common on rounds that are a higher valuation than their cap.

According to Mark Suster's earlier article - http://www.bothsidesofthetable.com/2012/09/05/the-truth-abou..., there are 2 main downsides to convertible notes from a founder's point of view:

1) If an investor invests $500k at a $4.5MM cap, he signs up to get 10% of the company assuming the Series A priced round will be at a higher valuation. But, if Series A is at a lower valuation, say $2.5MM, then the investor gets 20% of the company. However, if there was a discount associated with the convertible note then the note converts at 80% of $2.5MM. So a down round is really bad for the founder. But I can't imagine a down round being much better for a priced round.

2) If the Series A is $3MM at $12MM pre with 1x liquidation preference, the Series A investor gets 20% of the company. The seed investor who invested $500k will have his shares converted at the $5MM valuation. However, he will end up with a 3x liquidation preference or $1.5MM in liquidation preferences. I think this is okay as long as you raise a few hundred thousand dollar convertible note seed round. If the convertible note seed round ends up to be in the $1MM range I think this can become an issue for the Series A investor which is Suster's main point.

Convertible notes have benefits like high resolution financing, less control & no board seats. I still think convertible notes are the way to go if you are raising a few hundred thousand dollars in seed. But if you raising a seed in the $1MM range, it seems like priced rounds are preferred.

re #2: Yes, many notes have the provision to make sure the investor gets a 1x preference on dollars invested (some preferred and some common for their investment.) and this is, IMO fair.

re high resolution financing: if you are offering different investors at different prices, you are likely to make your investors less than happy with you.

re less control and no board seats: in my experience, having a board correlates strongly with success. so i think this is a negative. to put money where my mouth is - for my last startup, I took a board even though I did not have to.

re raising a few hundred thousand or less: in my experience, strongly correlated with startup death.

re high res financing: closing dates can also vary in addition to cap. i've personally experienced varying closing dates with same cap and the initial bit was much needed at the time. haven't experienced priced yet but can imagine process being a bit slower.

re less control and no board seats: agreed. though i think it depends on the board member. in your case, i'm sure he was top notch :)

re raising few hundred thousand or less: hmm, don't have enough data. but uber's initial round was $200k. https://angel.co/uber

Uber was cofounded by someone with a large exit. This number does not represent the actual finances available and is likely misreported. I have a single exception to the low initial raise as well. Still anecdata and does not really refute the point. There are successes, but there are way, way more failures; early investors hate to reinvest pre-traction.

Just having the dynamic of "down rounds" harms some of the value proposition of convertible note seed funds --- the C.W. behind them suggests that you can use them to raise casually, without freaking out about company valuation. But if they create a signaling problem for an A round, operators need to be just as careful with pricing the notes as they would with their A round, and A round pricing is arduous.

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