The prevailing wisdom among entrepreneurs these days is that they should initially fund their startups with a $1-2 million convertible note. The logic is that raising a convertible note, even a capped one (as most are), is less dilutive, and perhaps faster, than raising a priced round from an institutional venture capital firm that typically seeks a minimum ownership level. But in many cases founders are shocked at the dilution they suffer when, after having raised a convertible note, they raise their first priced round. Too late, some realize they would have been better off skipping the note and raising a full series A right off the bat.
Here is an example. Say a founder raises a convertible note of $1 million from a variety of angel investors at a capped pre-money valuation of $5 million, so that upon conversion the note holders will own approximately 17% of the company. With the $1 million runway, the founder is able to make a few hires, develop the initial product, maybe even launch. Now the founder goes out to raise a $3 million series A. The product looks good, the team is credible, but there isn’t a lot of data yet on market adoption, so a series A investor offers a term sheet at a $12 million pre-money investing $3 million for 20% ownership. The venture investor is also likely to require a 10% unallocated option pool post the closing of the round, in addition to whatever options were already granted to make the initial hires. The net result is that, after the series A closes, the founder will have taken a cumulative dilution hit of over 50 percent – yikes! In companies where there are multiple co-founders and the equity pie has already been sliced up, this gut punch can feel even more painful.
Now let’s consider the alternative. The founder skips the convertible note and seeks a $4 million priced series A investment right at the start. The question a founder should ask herself is: above what pre-money valuation will I be better off? In this example, assuming the venture investor requires the same 10% unallocated option pool, any valuation above a $6 million pre-money will be less dilutive to the founder. Most venture firms seek 25-30 percent ownership if they invest single-handedly at the pre-product stage, so with the unallocated options, a founder could potentially expect 35-40 percent total dilution. Moreover, with this approach, the founder has the runway to fully launch the product with a committed investment partner at her side.
To be sure, not every founder is able to raise $4 million at the pre-product stage, but I’ve been surprised at the number of entrepreneurs who don’t realize that they can. If you have a successful leadership track record, particularly in product, at a company in a similar domain to the new one you are founding, you have a good shot at it. And the series A valuation you can command pre-product may not be too much less than what you could command post-product. In other words, the pre-product valuation will already build in an expectation that you can deliver on a great product. When I look across Trinity’s portfolio, there are a number of entrepreneurs and companies that we have backed at concept stage, including Anthony Soohoo at Dot&Bo, Anna Zornosa at Ruby Ribbon, and Charles Huang at GreenThrottle.
A founder could legitimately argue that the “Sand Hill shuffle” of raising institutional capital is time-consuming, while a convertible note can be raised quickly. Less time raising money means more time building product. Fair enough, but traditional venture firms can move surprisingly quickly when a company is aligned with their investment theses and when there is only the market opportunity and the team to diligence. If you think you potentially have the cred to raise a venture round pre-product, do a quick market test with a few warm intros to VCs. If you don’t see the VCs’ eyes light up, move on to plan B, the convertible note.
Not every founder wants to raise $4 million at the pre-product stage. The more capital you raise, the greater the responsibility felt by some entrepreneurs and the higher the expectations of most investors. Having less capital can also help founders impose a natural discipline around the burn rate and can foster creativity and resourcefulness on the team. However, even for a smaller amount of capital, a priced equity round at the outset could ultimately result in less dilution for the founder. But importantly, the founder should seek out a venture investor who is like-minded about maintaining a low burn rate and open-minded about iterating the business and even completely pivoting if necessary.
If you are a founder deciding whether to raise a convertible note or priced equity, be explicit about your business assumptions: the key milestones you will hit, the capital requirements to achieve them, and the valuations you can then command. If you think that you will make tremendous progress on a $1-2 million convertible note, such that the first institutional round will be priced quite high, then that may well be the way to go. Unfortunately $1 million is spent quickly, especially in the startup mecca of Silicon Valley, and market conditions, over which you have no control, can whipsaw valuations! But if your business assumptions are realistic, you are likely to get the right answer, and you may be surprised that the right answer is to initially raise a priced equity round.