Has convertible debt won? And if it has, is that a good thing?

Paul Graham, founder of Y-Combinator, sent out a tweet on Friday saying: “Convertible notes have won. Every investment so far in this YC batch (and there have been a lot) has been done on a convertible note.”

It’s an interesting data point on Y-Combinator companies, but is this truly a macro trend? Have convertible notes really won?  And if so is that good for start-ups? Good for investors?

I think the answer to these questions are that 1) it’s not at all clear that this trend is as definitive as Graham suggests; 2) it’s a mixed bag for entrepreneurs (more positive in the short run, potentially negative in the long term); and 3) it’s clearly not a positive trend for early-stage investors.

First a quick terminology recap (skip this paragraph if you’re already familiar with convertible debt vs. preferred equity). The most common forms of investment in early stage business are convertible debt and preferred equity. Convertible debt is exactly that – debt which is convertible into equity at some later point in time (or is paid off). Typically this conversion is at a discount to the next equity round (to compensate the debt investors for their risk) and sometimes carries warrants (same rational) or a cap on the equity price that the debt converts into. Historically convertible debt has been easier (and therefore cheaper) to put in place. Preferred equity is stock which carries with it certain rights (preferences) in terms of how and when it gets paid back and a handful of other items that relate to the control of the underlying business.

Also, before I jump into this let me state that I have the view that, like many things involving start-ups, there’s a balance between what’s good for investors and good for entrepreneurs (there’s a symbiotic relationship between the two). I believe in cutting fair deals with entrepreneurs and don’t at all subscribe to the belief that an investor should try to obtain harsh control or preference terms (almost all of our investments at Foundry have a 1-times preference multiple and are non-participating; see this post by my partners Jason and Brad for more details on what these terms mean if you’re unfamiliar with them). Paul himself said in a March 2009 article: “When you hear people talking about a successful angel investor, they’re not saying "He got a 4x liquidation preference." They’re saying "He invested in Google." And I believe that’s true, although as you’ll see below, I also believe there also has to be reasonable compensation for the risk that early stage investors are taking. We should all be so lucky as to find the next Google, but one’s investment strategy needs to be geared to finding the next Mint or del.icio.us.

Has Convertible Debt Won?

I asked this question to a number of angel investors (all with institutional angel funds or running Y-Combinator like programs) and the results were mixed. Interestingly there seems to be  a real split between the coasts. While all of this year’s Y-Combinator investments have apparently been structured as convertible debt, that’s not the case with other programs. While some are clearly seeing a heavier weighting to convertible debt than to equity, one east coast based program I talked to told me that fully 100% of their companies who had received funding had done so in the form of equity.  Of the super-angels I talked to, several reported that “all” or “almost all” of their initial investments were currently being structured as convertible debt with one (again, east coast-based) exception who reported only 5-10% of their deals were structured as debt. It’s hard to say where in the country the line shifts from equity to debt, but it’s clearly a much stronger trend out west than on the east coast (at least the northeast which was where the firms/programs that I spoke to on that side of the country are located). To be clear, any west coast trend by definition is trend, given the skew of investing to that geography (and by far the majority of the so-called super-angel investors are west coast based).

The trend that Paul is pointing out appears to be taking place, but is less than definitive (and much less so than I expected). 

Now on to by far the more important question – Is this trend a good one for entrepreneurs and investors?

Traditionally convertible debt is used for initial funding rounds that are smaller in size, where the financing isn’t substantial enough to cover the greater legal costs of a more traditional seed equity round, where the investor base lacks a “lead” to price and negotiate terms, or where the financing size is such that all parties agree that not enough money is being raised to put a stake in the ground around pricing. As I noted above the conversion terms typically contain a discount to the next financing round and – according to the super-angels I talked with – also almost always contain a cap on the price at which the equity can convert at later. Both these terms are designed to bound the risk that the convertible debt investors are taking in not pricing the round – they’re investing in an debt-like instrument with equity like risks.

Entrepreneurs like convertible debt for some obvious reasons. For starters, it can be much quicker to put together a convertible debt financing, so more of the capital being raised goes to the operations of the business, not to the lawyers (this clearly benefits both the entrepreneur and investors). Importantly it also puts off the valuation question to a later date and tends to shift at least some risk from entrepreneur to investor (I’ll talk about why this is in the next paragraph below). Interestingly however, with the increasing number of seed financings we’ve also seen a decrease in the complexity and cost of equity seed financings such that they more resemble in time and cost convertible debt structures (both Y-Combinator and TechStars have model seed docs up for those wishing to further streamline the process). As a result I believe some of the perceived difference in time and cost are disappearing and less relevant to the debt vs. equity debate.

It’s the question of terms that’s key to the investor side of the equation and where I believe the convertible debt trend starts to fall down. In the investor’s best case scenario, the convert terms reflect the current market value of the business (specifically, the cap appropriately prices the equity value of the business at the time of the debt investment). However the investor hasn’t actually purchased equity and has opened themselves up to an easier renegotiation of their terms by a later investor (who, almost by definition, wields more power at that time than the original angels, assuming the company actually needs to raise capital). More likely, however, the convert cap reflects a premium to the current fair market value of the business. One super-angel I talked to told me that while a year ago these caps “approximated what I’d pay in equity” that they’re now “33% higher than what I’d normally agree to pay now.”

I have no doubt that the convertible debt structure has the effect of raising prices for early stage investing. Within some reasonable range this isn’t a huge problem – early stage valuation ranges move up and down with the markets – but in larger increments (which we’re seeing now) and viewed in the light of angel investing economics, these changes in early stage valuation may be problematic.

Traditional venture investors average up their cost basis in a company and “protect” their ownership over time by investing in subsequent rounds. Often, angel investors don’t participate in future rounds (or if they do, they do so at a much less meaningful percentage of the round) meaning that their initial buy-in forms the basis for the majority of the shares they ultimately own in a company. Ironically, the trend of companies raising less capital actually enhances the importance of the initial round buy-in (both because that initial buy-in becomes less diluted meaning the first round price was that much more important and because even if an angel wants to buy up more in later rounds they’ll have less of a chance to do so; I also believe that along with the trend of companies raising less capital we’re also seeing earlier and somewhat smaller average exits – also enhancing the value of initial round buy-ins as fewer investors are truly swinging for the proverbial fence). I’m a big fan of the rise of the so-called super angels – I think they’ve been great for the overall entrepreneurial ecosystem and I’d like to see them continue to thrive.

So how is this trend bad for entrepreneurs?

Clearly in the short run this trend is positive for entrepreneurs because it has the effect of both deferring an often difficult conversation (around valuation) and ultimately increasing early stage company values and as a result decreasing entrepreneur dilution (by the way it’s also good for Y-Combinator, TechStars and other similar programs since the shares the program gets of each company act as founder shares in this financing equation). And I have no doubt that there will be many entrepreneurs who benefit from this trend. But it’s not clear to me that it’s sustainable (just as it wasn’t a decade ago). Ultimately investors need to be compensated for the risk they take in making their investments. With capital being relatively fluid (and the angel markets being finicky) as companies run into trouble, as valuation caps begin to be disrespected, as overall return profiles decrease because of higher early stage prices, money will flow out of the asset class. And ultimately this doesn’t benefit entrepreneurs either.


If you’re a long time reader of this blog you’ll know that I don’t like superlatives and I don’t like sweeping generalizations. I don’t think convertible debt is bad and I don’t believe as famous angel investor David Rose has said that “Smart Money’ doesn’t invest in convertible debts. Period.” Different situations call for different capital and financing structures. That said, a broad market trend towards convertible debt has implications that I think are bad for the overall early stage investment ecosystem.

I look forward to a healthy discussion in the comments below!

Quick disclosure note, I’m a personal investor in TechStars and from that end actually benefit (at least short term) from this trend. As an angel investor I’ve participated (this was prior to raising the Foundry Group fun) in convertible debt structures, including several very positive outcomes.  I’m also an investor in several angel funds that are in the middle of this market. Foundry itself rarely (which is to say never to date) structures a first round as convertible debt.  

  • hdemott

    So once you wade through all of this – what you are really saying is that convertibles are essentially a lot like preferred equity – only without a price. But the issue is that while the pricing conversation is essentially deferred – it is really not – because of the issue around the cap at which the conversion will occur.

    So, since you effectively have to price the two issues (preferred or the conversion cap) either way – the only issue is really the cost of debt over equity (lower) and the issue of not having a definitive lead willing to put a stake in the ground.

    I've done em both ways (as have you obviously) and I'm not sure there's a real difference in outcomes other than the cap negotiation – and the deferred legal fees on the first preferred offering.

    • sethlevine

      Thanks for the comment Harry. I think that for some reason the pricing conversation around the cap is perceived as easier than a true “let’s price this round” conversation, although the dynamic is similar. I think part of why that conversation is easier is that for investors it’s one stepped removed from the question of what the business is worth NOW. I believe this results in the entrepreneur getting a better deal and is at least in party why the economics fall down. I also don’t believe that these caps are going to be respected once the market cools off and will result in even worse economics for angel investors (they’ll get the benefit of the cap where it doesn’t matter).

  • On my Angel investment side, I invest using an equity instrument almost entirely. One of the big risk factors I am always looking at in early stage investing is the self-awareness and a realistic view from the entrepreneurs themselves. If they are unrealistic about the valuation and I am forced to use convertible debt to reach a deal, this suggests a potential bigger issue. (With that said there are exceptions to every rule)

    Seth, great job laying out the argument for both sides of the equation.

    Steve Welch
    Co-Founder DreamIt Ventures

    • sethlevine

      thanks for the comment steve. the signaling point is spot on. we all talk about investing in the people more than the idea – this is doubly true at such an early stage.

  • Deckerton

    One thing I'd like to add is that delaying pricing not only shifts risk, it also protects the cap table, which may be more important. Angel investors chafe at the idea of getting worse deal terms than earlier investors, so delaying pricing means that all investors convert at the same terms, which reduces due diligence and speeds up the deal. Faster deals are probably more beneficial to some entrepreneurs than shifting risk.

    • sethlevine

      fair enough and it’s a good point lateef. this goes to the traditional notion of using debt when you’re not raising enough capital to truly set a stake in the ground around pricing. that said, it seems like more and more super angels are relying on the structure – and they both have the capital and the experience (not to mention relationships with institutional funders) to protect themselves.

  • marksuster

    Too funny – I just wrote about this yesterday albeit on Quora vs. my blog. Somebody had asked the question, "Why would an early-stage investor specifically NOT prefer a convertible note structure to straight equity" and I couldn't resist laying in. Full answer I wrote is here: http://bit.ly/aLoMTI – but short answer is

    – convertible debt with no cap is a trend that is more prevalent in frothy markets and will wane in tough markets. investors who do it fear "missing out on a deal" – not the behavior of solid long-term investors
    – smart money doesn't invest in convertible debt with no cap (link highlights why)
    – the increasing trend is actually convertible debt WITH a cap. This can actually be worse for the entrepreneur because it sets a max but not a price
    – primary reason FOR convertible debt is that the legal process is faster and less costly
    – YC is a unique situation because they have a mass of companies applying to be part of a program which doesn't emulate the broader market conditions. Note: I didn't take Paul Graham's statement to mean that it had "won" for the entire market. I'd be interested to know if he thinks that.

    • Justin


      Do you think convt with a CAP should have a discount or warrants? We've recently moved away from discounts in an attempt to speed up subsequent investments. I'll let you know if it works.


      • sethlevine

        I generally don’t like warrants (the math can get too complicated and I’m more in favor of being explicit about the terms).  One thing I didn’t mention about the cap (that I should have put in the body of the post and that Mark Suster noted in his comment) is that with it you also run the risk of signaling to future investors around pricing in a way that’s different than you would if you had a previously priced equity round. While everyone understands the deal, new investors still view debt conversion as somehow a concurrent event (i.e., as if they are participating in the new round) and I think in some cases either won’t respect that cap or use it as an implied ceiling for future valuation.

      • sethlevine

        I generally don’t like warrants (the math can get too complicated and I’m more in favor of being explicit about the terms).  One thing I didn’t mention about the cap (that I should have put in the body of the post and that Mark Suster noted in his comment) is that with it you also run the risk of signaling to future investors around pricing in a way that’s different than you would if you had a previously priced equity round. While everyone understands the deal, new investors still view debt conversion as somehow a concurrent event (i.e., as if they are participating in the new round) and I think in some cases either won’t respect that cap or use it as an implied ceiling for future valuation.

    • My experience as a lawyer on early stage deals is that convertible notes don't usually cost less overall- they just spread the cost over 18-24 months instead of all at once.

      A company that raises a Note round, then a Series A according to the "plan" probably would save money, but in my experience most end up extending Note terms, taking a second round of Note investment, converting at less than the Series A target, etc.

      With numerous exceptions, I generally advise clients that for ~$250k or less, Notes will use less of the proceeds on legal fees and make for a cleaner cap table. Above that they should just bite the bullet and do equity.

      • sethlevine

        Jay – My experience more recently is that first round equity and debt cost about the same to paper. This wasn’t true 24 months ago, when I do believe that debt was cheaper, but I think the markets have moved such that there’s little difference (and your point about debt sometimes just spreading out the financing costs is a good one). Thanks for the comment.

    • why do you post long form content on quora without reposting it on your blog?

      i don't use quora so i would never see it except for the fact that you left this comment

      i think you should be cross posting your good stuff on your blog

      that is your brand

      everything else, twitter, facebook, quora, stack, blog comments is distribution

      • What a nice helpful piece of advice! You, Fred Wilson, show all the signs of being a very kind person!

        I actually did read Mark's comment on Quora a few weeks ago. And I think the content of his comment here (and there) is correct. But I'll post my thoughts in the correct thread.
        *Your comment to Mark is relevant to me too…..

  • Deckerton

    Gotcha. I'm still on the lookout for super angels in Nebraska. My perspective is much more informed by "micro" angels, (though I'd never call 'em that to their face). ; )

    • sethlevine

      yah – i don’t know that i’d point that out to them!

    • sethlevine

      yah – i don’t know that i’d point that out to them!

      • Seth, merely an FYI. Your reply to Deckerton on your Aug 30 blog post about angel financing using converts was duplicated by Disqus comment system. Actually, it was quadruplicated!

        You probably will want to carve out the extras. ;@)

    • sethlevine

      yah – i don’t know that i’d point that out to them!

    • sethlevine

      yah – i don’t know that i’d point that out to them!

  • Good post! As with all things, I don't think there is an absolute answer. At FirstMark, we've done it a bunch of different ways depending on the circumstance. I'd say we have a bias to a simple, very clean equity deal for reasons above/below. And we've gotten it down to being as almost as efficient as a note deal. But it always has to depend on the context!

    If a company has already raised $1-2MM and needs an additional $250K to get a valuation defining deal signed or crossing a milestone metric (1MM uniques, $100K MRR, 10th customer, whatever), then as insiders we will do a very basic uncapped convertible note. If the main goal is to successfully raise a subsequent round at a great valuation, then the last thing you want to do is signal pricing… Any new investor will say, "Why should I pay much more than what you did two months ago?" Or worse, you might price it too high and scare people away before you can get the competitive dynamic working. You also want to signal excitement. Given we already have our "foundational" ownership, a clean deal indicates to someone coming in that you have full confidence in the team and the extra amount was truly about "crossing t's and dotting i's" versus eliminating risk.

    If a company is looking to raise a true round of capital to eliminate business risk and execute, then we will price the round whether it's a convertible with a cap or an equity deal. Most of our deals get structured as equity, but we have a very clean preferred structure with limited rights, and we simply include a clause that says we will inherit the rights of a future financing for things that are irrelevant at this stage (reg rights, etc). This mimics the best thing about a convert. Working with the right service providers who get this segment, it's virtually as efficient. But we like it because there is a clean handshake on what we have and do not have, however simple. It's done, in the books, with stock in hand. There are times where there is an inherent preference for a convert (usually because people have been told it's way more efficient) or we are joining into a syndicate, and we will also do the convert but it'll almost always have a cap given we are funding equity risk. Both instruments are just means to an end, so we start with the end and work backwards without getting religious. It's never been more than a 30 second dialogue and I only get nervous when it turns into religious debate! 🙂


    • sethlevine

      Sounds like we have very similar philosophies Amish. I didn’t touch on it in my post, but like you we use convert structures to bridge from one round to another. It’s the “use convertible debt to avoid pricing a round” philosophy that I think is ultimately unsustainable (cap or not).

  • Jud Valeski

    interesting read. while you suggest that convertible debt allows the parties to avoid the complex pricing/valuation conversation, it seems like that's actually still part of the equation/discussion. a conversion price point is still reached (a cap at a minimum), and that feels like a valuation line in the sand. no?

    • sethlevine

      Part of my argument is exactly that (assuming you have a cap). It may abstract the conversation a bit (because you’re talking about a cap and not the actual equity value) but it should be the same dynamic. And part of the problem is that because it abstracts the conversation I believe investors don’t end up properly pricing the round and ultimately won’t have the right risk/reward equation to sustain themselves as investors…

  • Jud Valeski

    yea, this feels like a strange abstraction then. the price pressure on executing equity based financings seems real (and a good thing). if the costs get more inline, I think it's a true wash at the end of the day. while the price/valuation may not be as explicit w/ debt conversions (or whatever your vehicle), it's always there in the end.


  • Chris Hobbs

    As an angel investor, I prefer priced rounds because I think they create better alignment with the entrepreneur. Almost all the deals I see, though, start as convertibles (though many don't end up that way). The price discussion is a tough one, but it is a great filter for a reasonable founder.

    The big problem with converts for me is that you rarely are pricing correctly for risk. Even if I get a 20% discount on the conversion at the next round, that does not adequately reflect the risk I took 6-12 months earlier when I put my money in. But, as a working class angel, if I want to get into interesting deals, I may have to accept less than ideal terms. In effect, I pay for the privilege of probably losing my money–but at least it is getting flushed in an interesting way. Institutional VCs don't have such issues, and they only use convertibles for what they are really good for–short term bridge fundings. But a seed round is more often a pier than a bridge. You can ask for a low cap, but this is not really any easier a conversation than pricing a round.

    So really, it comes down to cost and speed. Converts have always been dramatically cheaper and quicker, but that is narrowing significantly with the open source templates. I still have yet to see the law firm that does not charge more for a priced round, however.

    Another advantage of a convert is if you are going to fund in dribs and drabs. With a step up over time in the conversion discount, you can do a rolling funding more cheaply with a convert, and still have some accommodation for risk. I personally don't like rolling fundings, however, as the founders tend not to get any work done when they are focused on raising money.

    • sethlevine

      I completely agree Chris. Converts often abstract the financing terms just enough to confuse the issue (the “issue” being that risk equity investing deserves risk equity return profiles). Although as you and others have pointed out, we’re likely seeing a market supply/demand problem (several angels told this to me directly when we talked before I put this post up – they have to pay to play as it were).

      On the legal pricing question we have been seeing law firms come down significantly in price for “vanilla” seed rounds. They’re probably still a bit more expensive than debt (depending on the complexity of the debt terms) but not a whole lot more.

      Appreciate the thoughtful comment.

  • Ciprian Patrulescu

    Can you elaborate on why super-angels are good for the entrepreneurial eco-system?

    Ciprian Patrulescu

    • sethlevine

      Ciprian – I think the angel layer in the funding ecosystem has historically been the weakest (and most capricious). While some firms (like my own) do participate in seed round, the vast majority of companies get their initial financing from angels (and friends and family). I love that some of this angel activity has been at least partially institutionalized (something I’ve been thinking about for at least a decade) – I think it has two very positive effects. The first is simply access to capital. Historically one of the challenges of angel rounds has simply been finding angels. I think the super-angels go a long way towards solving that problem. The second is professionalism. Every VC has a story about an angel investor screwing an entrepreneur. The more professional the angel investment class is the lower the likelihood is of this sort of thing happening (it will never go away).

  • Why not raise seed money using warrants convertible into common equity?

    All the features entrepreneurs seem to like in convertible notes can be had with warrants (or options). You can provide for the conversion price to adjust in ways that mimic typical convertible seed note terms. And you can delay negotiating a stockholders' agreement and papering the other aspects of issuing stock until conversion, just like a note. The only feature inherent to a note, which is that its holder will enjoy creditor status in a bankruptcy or liquidation, is rarely mentioned, although this is adverse to founders and probably not of much interest to seed investors unless the startup has significant assets.

    • sethlevine

      That’s certainly an option Zeke, however warrant math can be particularly tricky (and non-linear). I prefer the more obvious and straightforward pricing of equity (or even convertible debt with a discount vs. warrants). And you’re right on that last point – when early stage companies go bankrupt there’s little value in the creditor status of the noteholder (and often in these situations the notes are reclassified as equity anyway because of their conversion features).

  • it is worth mentioning another benefit of a convertible note: to protect angel investors from the VCs. If angels get common stock, they might be significantly diluted by the "options pool game." By converting to preferred, they stand behind the entrepreneurs until a VC comes in, but then they stand along side the VCs when it matters (i.e., at the liquidity event).

    • sethlevine

      typically when angels invest in they do so in preferred securities (with similar terms to what a VC would ask for).

    • sethlevine

      typically when angels invest in they do so in preferred securities (with similar terms to what a VC would ask for).

    • sethlevine

      typically when angels invest in they do so in preferred securities (with similar terms to what a VC would ask for).

    • You can protect a common stockholder from dilution contractually, by providing in the granting document that the company has to issue additional shares to that investor to make up for certain diluting events. Information and control rights can be had via a stockholders' agreement. Liquidation preferences that differ from those of other stockholders generally, however, do need a separate class designation.

      Incidentally, even if you are investing in convertible preferred stock, you still have to protect against dilution from additional common stock issuance, because your preferred stock is convertible at some point into common. The conversion ratio would determine your take in a sale or liquidation even if you have not converted.

      Convertible notes can be drafted to give early investors the right to convert on the same terms as later VC investors, and I suppose that is some protection. I have not seen an equity investment that allows you to do this. You'd probably need a put right allowing you to put your early equity investment back to the company if there's a VC investment, combined with a participation right to contribute the put consideration in exchange for the corresponding allocation of whatever the VC is buying, and on the same terms. Anyway, I think it could be done contractually, even if it's not common practice.

  • OK, and I have no problem with preferred stock deals. My point is that for those who say they prefer convertible notes, the advantages they claim are things that do not require that the investment be debt. Cap and discount provisions would work the same both for warrants and convertible notes. Conversion events also the same mechanics. The only wrinkle is exercise price, and presumably in a seed investment, that would be nominal (unlike incentive options where the exercise price is set to FMV for tax reasons).

  • Rob Shurtleff

    As you correctly point out there are no black and white answers in cases like this, just shades of gray. I am often asked by entrepreneurs how to structure friends and family financing, my advice is always to do it as convert with a discount or with a discount that increases with time. Friends and Family are often not sophisticated investors, thus their ability to negotiate or set a cap or price could be limited. Super Angels, Angel Funds and other sophisticated investors can make their own decisions. Many, many companies get their start with Friends and Family and the last thing an entrepreneur needs to be explaining is why the first professional round is priced cheaper then what Friends and Family paid.

  • Great post! Just to clarify my comment quoted in your last paragraph, that particular statement was made several years ago prior to the emergence of valuation caps as a standard term in convertible note rounds. So, the amended quote should be exactly the same thing that Mark Suster wrote above: smart money doesn't invest in convertible debt WITH NO CAP.

    The cap is the absolutely crucial thing here, because a note with a cap that equals what you would have priced the round at in the first place, is actually a good way to do a seed round these days. You lose many of the protections you'd get with a convertible preferred round, and you lose a bit of negotiating leverage with the Series A investors, but you gain speed, significant cost-savings, and many fewer headaches. I'd say that the deals we're doing here in New York are about 50/50 these days, with the choice generally being made on the basis of how likely a near-term larger round will be.

  • Guest

    It would help me a lot to get some input on how people are setting the cap, and what you're seeing in the way of caps. For example, I have a handful of angels prepared to put money into my start-up – I've seeded the business to date, and have worked with a bunch of fantastic freelance engineers to build a working prototype which we have tested with some alpha users (got great response). Now I want to hire a full-time core team to build and launch the beta (iterate, iterate) and am raising some angel capital to help fund that. Where should the cap be – at a price commensurate with an assumed valuation today, or commensurate with an expected and fair pre-money valuation at our Series A (realizing that we are trying to protect the angels from the situation where the Series A valuation is higher than anticipatied)?

    Related, what is the range for the Cap that you're seeing and negotiating for (Angels)?


  • KWat

    Hi Seth, thank you for this post! I have a question about the overall process of outside investors in start up companies – specifically limited liability companies. I have had some investors looking to directly purchase membership units in an LLC (no convertible note, no promissory note), is this possible or is it more advisable to do the convertible note or in the case of advisers/consultants, the profits interest grant instead? I know this isn’t directly on point for your post above, but I’m struggling with which route to go with. Thank you in advance for your help!