What Are Convertible Notes and Why Use Them?

Throughout our previous entries on raising funds as a startup, we’ve been talking about raising money for your company by sharing equity with venture funds.

When you’re a company in its early days, sharing equity is difficult. Moving equity from your company to another requires a lot of time to hash out an agreement everyone can live with and it requires lawyers to work out the actual contracts. The whole process can cost upwards of $50-$100K, which is a lot of money for a company still looking for its first round of seed money.

Rather than dealing with the hassle of transferring equity, a lot of venture funds find it better to offer funding to startups using convertible notes.

Convertible notes are debts that convert into equity when a startup raises an actual equity round of funding. In essence, the venture fund offers to give you a loan of whatever amount, but instead of paying them back in actual money, the startup agrees to pay them in preferred equity. The venture fund gets the same agreement as whoever has invested in the series A round, with a bit of a discount as a good faith offer for investing earlier.

Early investing venture funds often find working with convertible notes preferrable to working with equity transfer for a few reasons:

For one, issuing a convertible note is easier. It can take weeks of discussion to transfer equity, but you can really issue a convertible note in only a couple of days. They also make it easier for the venture fund to work out the valuation of the startup by putting the discussion off until the series A round, when there is actual data to base their valuation on (rather than just a hunch). That considerably lowers the risk of their investment.

For startups, the convertible note also simplifies things. Convertible note agreements are short, maybe ten pages at most, and they can often be found online and modified according to the template.

Instead of the high cost of hiring a lawyer to transfer equity, the documents for a convertible note can often be found online. As a result, they can help generate quick funding in exchange for onle a few hundred to a thousand dollars. For a company that has limited time and financial resources, that is a tremendous advantage over complicated agreements.

Key Takeaways:

  • Convertible note are a form of debt taken on during seed funding that converts into equity when a startup begins an actual equity round of funding (usually in series A).
  • Convertible notes are preferrable to startups because they are quicker, easier, and cheaper to issue than equity. They are better for venture funds because they make valuation more flexible.
  • You can find a lot of online templates for convertible notes that you can use. Usually a lawyer is only needed in a limited capacity when working out a convertible note agreement.

Links

Storytelling For Startups

In light of our recent Storytelling for Business course announcement, this Founder Friday, I wanted to talk about storytelling for startups and how you can improve your ability to pitch your startup.

I have four basic pieces of advice:

  1. Set up a problem. Do this before you talk about your startup or what you do. Convince the listener that the problem your product is trying to solve is real and significant.
  2. Stop with the Jargon. Don’t talk about about “leveraging big data analytics and optimizing the social graph” because no one knows what that means. Really dumb down what you’re talking about to the level that a five year old could understand.
  3. Make it personal. Tap into people’s emotions by using language that relates to the five senses — show rather than tell. You ideally want to make it concrete and somehow relate to your listener. At the very least, you should be engaging your listener in a dialogue instead of just talking at them.
  4. Use common storytelling beats. Such as the 3 act structure (Exposition, Rising Action, Climax), the 5 story beats (Introduction, Incident, Stakes, Event, Resolution), or Dan Harmon’s Story Circle

No One Cares (About Your MVP)

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In this Founder Friday, I answer your questions about MVPs. Questions like:

“How early should I release my MVP?”

(It was basically just iterations of the same question haha)

Look, there are three parts to an MVP.

Product, that’s the obvious part.

Minimum, it should only have the features that it needs. Here you should tend towards less rather than more. It’s your baby and you’re afraid people are going to make fun of it, so you want to give it as much of a chance of success when you release it as possible so you keep adding all these features and polishing it up so it looks good.

But what you don’t realize is that by doing all that adding of features, you’re likely killing its chance of success in the real world — first, because you risk someone else coming in and building it before you, and second, because more features and more polish doesn’t necessarily mean better.

Many products that are successful are actually simplified products of things that already exist. Twitter is just Facebook without all of the other features, and a 140 character limit.

But what counts as minimum? Well that depends on the second word, Viable.

You will only have a GUESS as to what minimum features constitutes a viable product, and you have to actually release it to see if your guess is right. If your product is too minimal to be viable when you release it, then it won’t get usage. So what? No big deal. At least you didn’t waste any time building additional stuff that no one needed.

Then you can go back to the drawing board and think about how your product needs to change in order to be viable. But at least you got really useful information.

That’s one thing that a lot of people don’t realize. If you release your product and it’s not viable — aka no one uses it — then no one will care. It’s not like everyone will know your product is lame and will boycott it and never use it again. No — repeat after me: NO ONE CARES (about your MVP). And that’s a good thing. Now go learn something.

How Will You Make Money?

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You should have an answer to the question “How will you make money?” early on. You may even have several answers. It needs to be plausible, and people (like investors) may push back and argue with you about whether or not it’s a feasible business model. If you’re asking people for money, it’s a question you will have to deal with so you better be prepared for it.

That being said, you pointed out a few important things. For one, it’s okay to not be sure which will be the ideal business model or price. The process of getting to profitability is something you’ll have to face eventually if your startup continues to grow, but you may be able to push it off for a while in favor of focusing on growing usage. That’s the second point, if your product is growing quickly, you’ll often find investors willing to fund your growth despite the lack of a proven business model.

There are only a few major business models though: Advertising, Subscription, E-commerce, Business Development, and Lead Gen are some of the major ones.

Let’s take Facebook as an example. In the early days, Facebook was growing so fast that they were able to get a ton of money before they had to worry about their business model. But it was pretty clear their business model was going to be advertising. It’s a fairly straightforward path to monetization for a social network — though not all social networks monetize solely through advertising (LinkedIn charges users for premium accounts).

There are some others (like Medium) where the business model is still unclear, but I bet that the founders have a path (or several) towards monetization in their heads.

Yes, solving a problem should be the most important thing for you to focus on. But the reality is that if you’re trying build a big business, you have to have an idea how it’s going to be a lucrative problem to solve.