Convertible Notes – Weapons of Mass Destruction

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When the 2008 financial crisis happened, Warren Buffet called derivaties contracts used on Wall Street “Financial weapons of Mass Destruction.”

Working within a convertible note for my current startup, I think this is our start-up equivalent. To put things into perspective, I’ve raised 2 equity rounds for my previous startups ($4.5m in equity financing) which got acquired. I’ve been full circle and can compare notes to equities on a first-hand basis. So let me explain what’s so different about a convertible note. 

To take trading in stocks as an analogy, when you are long a stock, you only have to be right about the call. It can take weeks, or months, or years for your investment thesis to come true. You’re not bound by an artificial timeline. You only have to be correct about the call (price going up), not the exact timeframe. However when you short sell or do futures contracts (a derivative), you have to be right about 2 things – directional price AND timeframe. A typical short contract will say you think Facebook stock will go lower by 8% in 12 months, and that’s your bet. You could be totally right about the price decline, but it might take 24 months, or even 13 months, and you’ll lose all or most of your money. 

That difference is the key. 

It’s the same with convertible notes vs. equity financing. When I first did a convertible note for $1.3 million last year, it was keeping with the times. YC, 500-startups and other incubators made this a de-facto standard. In its simplest form, a note is structured as a loan, that converts into equity within a set timeframe based on new investment coming in. However new investment won’t come in unless your start-up is killing it within the alotted time. Equity financing converts into equity immediately without any artificial timeframe. It’s exactly like the long and short trades with stocks. Convertible notes have a fixed expiry on them, like a can of food in your fridge.  

You can be right about your product, have confidence in your team, believe in the market etc. But if you’re late by just a few months at “succeeding”, investors can sink your company. At that point, they control your destiny, not you. 

For that one reason, and its a big one, I think convertible notes are going to destroy more startups than they build. 2013 will be the year when you see carcasses of dead Silicon valley start-ups everywhere when the bonanza of convertible notes issued in the angel investing bubble of 2011 and 2012 start to expire. 

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