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Investing as a founder vs. via convertible note?

Here's a scenario: 3 founders have started a company with, initially, equal equity split between the three of them. Things are moving forward nicely but more cash is needed so it's time to take some Angel funding via convertible notes. However, two of the founders also want to put more $$$ into the company - the 3rd founder can't afford to do so. 3rd founder doesn't really want to be diluted relative to the other two so he suggests that they put their additional money in as convertible notes under the same terms as any Angel investor.

Any comments on this scenario? Does it make sense for founders to put money in as convertible notes? How will that be seen by future investors when there's a valuation round?

16 Replies

Joseph Wang
0
1
Joseph Wang Entrepreneur
Chief Science Officer at Bitquant Research Laboratories
I think you would be better off just having the two founders put in funds as a straight loan to the company. At the point where you are looking for addition investors, the founders can then renegotiate the terms of the loan with the company. (And in fact, it's all but certain that there will be some renegotiation at the time you receive additional funding.) You do run the risk that one of the founders will try to hold the company hostage at some point, but if that happens the company is in trouble anyway.

The problem with doing a convertible note is that it commits the founders to certain things happening when you receive additional investment. Once you have additional investors, you either have to renegotiate the terms of the note (at which point you have the same situation was if it were a straight loan) or else you don't, at which point have convertible notes outstanding will just complicate your valuations.
Irwin Stein
0
0
Irwin Stein Advisor
Very experienced (40 years) corporate,securities and real estate attorney.
There is no right answer here. The company needs money and can sell notes or equity and notes. If the 3rd Founder gets outvoted and diluted he/she may be upset. This should have been dealt with at the time the company was set up in the original agreement between the 3 founders. Odds are that the need for additional capital was known then as well as the unequal ability of the 3 founders to add capital. A good lawyer drafting the original agreement would have covered it. Now its a distraction. The ball is in the court of the majority. This sounds like it is more about personalities and relationships than money.
Joseph Wang
2
0
Joseph Wang Entrepreneur
Chief Science Officer at Bitquant Research Laboratories
For small companies, it's always about personality and relationships more than money.
Orion Willow Parrott
5
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Orion Willow Parrott Entrepreneur • Advisor
Founder and CEO, Lendsnap YC S16. We're hiring!
I personally recommend the convertible note scenario. It makes it easier to separate the cash vs (apparently) fair equity split. The convertible note will dilute the 3rd founder eventually if it converts, but fair is fair. There are also tax and balance sheet implications to each scenario. My belief is investors look more favorably on the convertible note (as opposed to a non-convertible simple loan) because it won't generally be paid back upon raising funds(depends on terms), which would reduce operating capital available to the business. One modification would be for the founders to put their cash in as SAFEs which are not debt on the company books at all. Outstanding convertible notes don't add much complexity, particularly when the note holders are already on the cap table; they're just more paid in capital, subject to the same calculation as other investor money.

If the founders don't get a SAFE or note for their cash contributions, then what is the alternative? Somehow arbitrarily assigning a fair value to the cash contribution in terms of % ownership of the company. That would be forcing (implying) a valuation on the startup at the earliest stages. Early valuation is not just complicated but subject to significant error in any case. The SAFE or note solves this problem for the founders.

Another reason investors might look more favorably on the convertible note instead of a plain note is it signals commitment and investment in the business. Shouldn't the entrepreneur be long on their own startup instead of playing it safe and earning 0% or nominal interest? True, there is no right answer, it still depends on the particular circumstances. Some people would say the founder should not also put their own money in (or not much) because the external validation of raising funding is another positive signal. Founder investment can help start that tide.
David Austin
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0
David Austin Entrepreneur
Entrepreneur
The ownership was something on which they all already agreed, yes? Then they should honor that agreement. Personally, this partnership does not seem to be a healthy one to me when co-founders start doing stuff like this that run afoul of the original agreements they had in place, especially to profit at the expense of another co-founder. That, as in investor, would concern me. If they use convertible notes instead then that means they are cooperating and honoring their commitments to each other, which investors like to hear. Healthy team dynamics is everything when you go to a group of investors. That's what they want to see. I don't know what their problem is ... convertible notes are a good deal if they structure it right. There should be a scheduled payback equivalent to the risk involved.
Michael Brill
5
0
Michael Brill Entrepreneur
Technology startup exec focused on AI-driven products
I'd stay away from the convertible approach as it now creates different motivations for the founders - especially if things get tough (and they typically do). The 2 investors may make decisions more motivated to benefit the Series A shareholders while investor 3 will always be more focused on the outcome for common. Even if this doesn't really manifest in decisions, it'll be in everyone's minds and be a source of conflict at exactly the time when the 3 of them need to work together.

Also, it's a slight exaggeration, but a convertible note essentially means 2 founders are just *giving* the company money in most scenarios. It's not likely a large amount of money and it'll convert to a very small amount shares relative to their founders' shares. Yes, there's a liquidation sweet spot (e.g., <= 1X Series A size) where founders would get some of their money back, but statistically it's not likely. Kind of a crap deal for the 2.

A straight note at least has some potential of being paid back... and investors may not grimace if it's negotiated to be paid back at some future time when cash flow allows... or it could simply be negotiated into converting at Series A. In any case, this provides founders most flexibility and doesn't instantly create two tiers of founders.

Depending upon amount of money, another possibility is to improve optics by having the employees paying for some of the expenses directly and then simply file expense forms... it'll now sit on the balance sheet as a payable, not as debt. Psychologically, investors are less fussed about paying back bills than they are paying off debt.

I guess a final approach would that the three amigos all do the same thing (whatever it is) but have the company lend amigo 3 the money.
Martin Omansky
1
0
Martin Omansky Entrepreneur
Independent Venture Capital & Private Equity Professional
Investors will elect to live with any result, or they will pass. You have little control. Also your founder can't avoid dilution. Something about the law. There are ways to handle this, however, but he and you can't a kid consequences. I suggest you talk to a tax attorney a out this matter. Sent from my iPhone
Ken Anderson
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0
Ken Anderson Advisor
Director, Entrepreneurial and Small Business Development, Delaware Economic Development Office
You have arguably put yourself in a tough spot where the convertible note option may be the best of a number of bad options. In my opinion, splitting equity equally among three co-founders was a mistake. It would have been better to slice the equity pie more based upon actual value being brought to the business, which at this point may have given you a more palatable option than the one you are considering. Consider revisiting the equity split to avoid this problem in the future....a split based upon actual value to the entity.
Suryanarayanan A
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0
Head, Incubator consulting services at Bhiveworkspace
Another option is optional convertible note. This gives the 2 founders to convert it into equity at their option at a certain discount to the next round of funding and till then a fixed interest accumulates. They can also opt for refund of debt and interest if the next investors agree.

Len Chermack
0
0
Len Chermack Entrepreneur
Software Executive in Cloud, Iot, Enterprise & SMB. Proven in Turnaround and Growth in Sales and Services
This is difficult to answer without knowing the effect on the partner who cannot contribute cash. What value does this partner bring that the two with cash are unwilling to perhaps take a greater risk and therefore greater percentage of the company? You see, if these two partners put money in via a convertible note they already have greater ownership at time of conversion. So why have them jump through hoops? Have them put the money in as a loan and set appropriate terms. Perhaps they should receive a preferred note.

In any case internal money is better than outside money for better control at this stage. But if you need the outside angel too, all the better. That person is less attached and therefore if interested there is some validation on the belief you three are on to something.
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