First-time Entrepreneur’s Guide to a Convertible Note

April 25, 2011

My friend Tim from Cleveland called me to day and wanted a quick overview of how convertible notes work.  They’re pretty simple if you understand a few basic points.

First, use of this security is a way to avoid having to agree on a value for your business today.  What the investor/lender is really saying is “I’ll give you the money now and we agree that it will buy shares later when someone else comes in and establishes the price.”

Second, by giving you some money now, as opposed to waiting until everyone else ponies up, they’re taking more risk and are generally rewarded with a lower price per share, either via a straight discount or warrants to purchase more shares, plus interest at a reasonable rate.

Third, these notes generally include a mandatory conversion feature that says “if you raise a minimum of x dollars, I agree to convert my loan into shares of the round.”  If the note didn’t include such a feature, the lender could demand repayment which might enable her to take control of the company or at least its assets.

Most frequently, the term is one year but shorter or longer terms may be used depending on the circumstances.  Investors rarely want to own the companies they lend to so extensions are not uncommon.

But own them they can, potentially including valuable intellectual property so caveat borrower.  And get a good lawyer.


When are you ready to raise money?

April 11, 2011

You’ve got a great idea for the next social couponing service or massively customized hair braider and you need to raise some money to get it off the ground.  When are you ready?

I’m going to go with the copout answer here and say “it depends”.  It depends on a bunch of things: your track record, how much you are raising, how fast you will spend it, who you plan to raise it from, the background of you and your team, how good your network is, how good the general fundraising environment is and other factors.

Track record – If you have a successful exit (or several)  under your belt and your idea is solid, you may be able to raise money with a few phone calls and a PowerPoint.  If not, keep reading.

Amount – raising many hundreds of thousands of dollars from angel investors or millions from venture capitalists is hard and takes months.  Most angel investments are made in $25,000 to $50,000 chunks so you need a lot of those for a large angel round and you must be well prepared.  Raising $250,000 or less is easier and raising $50,000 from friends and family is easier still.  And of course how much you are raising depends on how fast you are spending it.  As a general rule, you should raise enough money to get you to some sort of “milestone” and then have a bit left over to give you time to raise some more.  The longer you can make a small amount last, the better.

Team – if you are a single technical founder (or team) or have deep experience in the business you are building, raising money is easier, not to say easy.  It also helps if you can live on a small salary.

Network – If you have a strong group of investors who know you well and trust you, raising money can be relatively easy.

Fundraising environment – As I write this in the Spring of 2011, it is a great time to raise money.  Many are calling it a bubble but I disagree.  One of the smartest bloggers I read, Ben Horowitz, had this to say.

Other factors – There are many but one I will mention is buzz.  Some people and teams are just good at creating buzz around a concept.  If you’re one of them, great!

So if you think you’re ready, it pays to be prepared and the more of the following (in no particular order) you have, the easier raising money will be:

  1. Analysis of the market: how big? how fragmented? who are the competitors? barriers to entry? who are the users? propensity to adopt new solutions? etc. etc. etc.
  2. Product: at least a prototype to demo, ideally, something in the market with evidence of market traction.
  3. Financial model: it doesn’t need to be complex but should reflect in detail the revenue model and costs to support it.  How will you sell and market this?  What are those costs?  How much will buyers pay and how will that change over time?
  4. Executive summary: can be as short as a page or two but must have enough information to pique the interest of investors.  The only goal of this is to get a meeting.
  5. Presentation: a short PowerPoint or equivalent to use when sitting down with your potential investors.  Keep it short and sweet.  Fred Wilson has a great post on this.
  6. Attorney: you will need a good one experienced in early-stage financing to help with the close so it’s rarely too early to get one involved.  If they like your idea, they’ll generally defer billing until you raise the money.

So get going!