The Myths of Convertible Notes

The Myths of Convertible Notes

A convertible note (“convertible”) is a loan made to a business whose terms allow the lender to convert the value of the loan into shares in a company, at a specific set of terms.

Disclosure: With VERY few exceptions, I believe that convertibles are significantly founder UN-friendly, cater to the lazy, or inept investor, and can provide significant financial return to savvy venture partners/lenders. Convertible investing may be BETTER for a founder than alternatives, but it’s never a GOOD investment.

Convertibles have been around for a LONG time, but really came into play in the dotcom boom of the late nineties. Why? Well let’s look at what was going on then.

By the mid-nineties AOL had successfully commercialized online experiences for consumers – it had become “your parent’s internet” and, of course, every business needed a website. DOT.COM startups were sprouting like weeds, and every venture fund was under extreme investor pressure to add this sector to their portfolio. It was this digital gold rush, that inflated the bubble, that led to the bust in 2001/2.

The problem was that no one knew how to value a startup, particularly as most (almost all) had NO path to revenue, let alone profit. And then the inevitable … “how to we put a valuation of this”? At one-point valuation was as simple as “

“How many developers do you have.”?


“Then the valuation is $4M”

That was the conception, and a very short gestation period later, the modern convertible emerged.

Google “what are the advantages of convertible notes”, and you tend to get two general points – and 20M hits:

  1. Legals are simpler, cheaper and quicker than a priced, equity round.
  2. Avoids having to value an early stage, probably pre-revenue company.

So, each of these myths:

  1. This used to be true, but with standardized term sheets, and SAFE agreements, this advantage has been eliminated. And even if there was still some premium to be paid for the legals of an equity round, the cost (in terms of founder dilution) is a rounding error (pun intended) compared to the next point.

  2. Valuing a pre-revenue company is not hard, I’ve been doing it for fifteen years, and there are half a dozen entrepreneurs walking around Belfast today who can also do it. It takes 15 minutes and a single spreadsheet.

Why then, are convertibles still around?

For starters, it’s usually a much better deal for the investor.

in certain cases, it can represent a 50% discount off the share price … meaning they can buy twice as many shares for the same price. And, depending on the terms of the round where the loan converts to shares, can secure liquidation preferences (i.e. on liquidation, THEY get paid back before any other shareholders) of xN times more than those other investors.

Then there are the philosophical considerations.

If the investor doesn’t know how to value a pre-revenue company, is this really the investor you need?

If the investor does know how to value a pre-revenue company, and yet still chooses to use convertibles, they clearly see the financial advantage, and may even exploit that advantage further, through valuation caps.

So, if you have a choice … before you choose an investment through convertible loans, ask “why do you prefer convertibles”?


It may be the quarantine creating more time on my hands, but I’ve had the opportunity to engage with several major technology vendors for support – and have been sadly disillusioned.

Lest startups equate market cap with support excellence, and think that emulating that is the right way, here’s a couple of thoughts:

  1. The support process, and in large businesses the actual organization, should be modelled around three levels:
    1. Level 1 … is to identify and fix any user problems
    2. Level 2 … is to identify and fix any known problems
    3. Level 3 … is to collect all information for development to fix any new problems.

      only Level 1 can be serviced by a bot and then, only just.

  2. FFDC … First Failure Data Capture is a very old school development requirement whose goal is to capture all the data that is needed to determine the bug and resolve it … when it happens and avoids support having to say “wait till it happens again, and display xyz”.

  3. “Restart the application/system will fix the problem” … NO, NO, NO.
    All this does is to [possibly] circumvent a bug and to lose the opportunity (at the time of failure) to collect problem determination data.

  4. “I think you have a corrupt contact/event/image/note … can you scroll through them, find it, delete it, and try again?” … yeah right, scroll through my 2,000 notes, 6,200 contacts and 170,000 images??? How about you write a simple little app that tests the integrity and structure of them and makes life easier for everyone”.

The Gestalt of Down Rounds

or … if Occam had a razor, Gestalt had a scalpel.

Clearly a topic for the very few, but if you’ve had Investment ready training, and think you know the terms down round and anti-dilution … read on. Founders need to wrap their heads around these two concepts, with surgical precision rather than bumper sticker buzz-words.

Taking anti-dilution first, it’s probably best to describe this in terms of dilution … which (in the simplest of terms) is a reduction in the percentage ownership in a business as a result of subsequent investments.

That bad, right?

Well, as expressed, that’s a question that cannot be answered.

As a founder, you may own 100% of the equity in your startup. Perhaps you started your business with £100, meaning that your business is valued at £100.

Cap Table after Registration … Founder has 100%

After a while you create a demo, and have an attractive plan, so you think the business is worth £1,000. And a seed investor thinks the same, is excited at the opportunity offered and invests £500.

Let’s look at the moving parts here.

Before the investment, your business was worth £1,000. After an investment of £500, your business is now worth £1,500 (£1,000 + £500). 

The investment of £500 bought 33% of your business (£500/£1,500) and your ownership was diluted by 33% to 67%.

Cap Table after 1st Seed Round

Bad?  No – good – in fact GREAT.

Before the investment you owned 100% of a business worth £100, or £100. 

After the investment you own 67% of a business worth £1,500, or £1,000.

Come on down!!! The box on the right has £100, the box on the left has £1,000, but it is labelled “33% diluted”. Which one would you choose?

OK, so dilution is explained. It’s not bad, it’s just a number.

Then what is anti-dilution? Hold that question, we need to delve into down round first.

In the simple example above, the valuation of your business increased from £100 to £1,000 … i.e. it when UP, and after the investment it is £1,500.

Let’s say you are looking for another investment, but, for whatever reasons (and we’ll look at these later), the investor states that – in their opinion – your business is really only worth £1,250, i.e. it went DOWN (from £1,500).

Cap Table after 2nd Seed Round

And that’s a down round, right? When the VALUATION goes down? No, it’s a down round because the SHARE PRICE went down.

Let’s take a sidestep and look at one of the many differences between public and private companies. 

When investing in a private company, the investor negotiates the company valuation (with the founder) and that determines the share price. When investing in a public company, the investor negotiates the share price (through public exchanges) and that determines the market valuation.

As long as there is a linear, 1-1 relationship between share price and valuation, then it’s OK to consider a reduction in VALUATION as a “down round” – even though the concept is irrelevant for pubic companies. But, for a private company, the correct definition is … a down round is a reduction in the share price of a business as a result of subsequent investments.

OK, some astute [or smart arse] readers are thinking … but’s that just another way of saying that the valuation went down, right? WRONG.

For that to be true, the relationship between valuation and share price must be linear and 1-1 and – for private companies – there are a number of circumstances where that is NOT THE CASE.

In general terms, any time shares are issued at less than the determined share price, the relationship between share price and valuation is non-linear.

Eh??? When does THAT happen?

Well, for starters convertible loans? For ESOP allocations? Granted founder stock?

Head hurting yet? Good.

Here’s an example …

Cap Table after ESOP Allocation

In this case the VALUATION stayed the same, but the SHARE PRICE went down.

OK, now back to anti-dilution … almost.

The essence of a down round (but PLEASE use a reduction in SHARE PRICE as the definition – it works in every case) is that a previous investors value – in £ terms – decreases. This may be because:

  1. the previous investor was a poor negotiator
  2. the current investor is a great negotiator
  3. the potential exit valuation changed or (a) market reasons or (b) company performance reasons

Enter anti-dilution terms!!! A sneaky device, designed to either protect the early investors or (the cynical view) create more ways for a VC to get more of your business.

Anti-dilution is REALLY a misnomer anyway … its not dilution that it’s compensating for, its a decline in the value of shares owned. But we have to go with that term.

I first encountered this in 1985, but I believe it was conceived twenty years earlier. It also became commonplace in 1998 and 2008 and appears to be ubiquitous today.

The concept is generally the same … in the event of a down round (specified in the investment agreement as a drop in share price), the investors who own preferred shares (usually not the founders) get compensated with addition common stock to restore the value of their initial investment. The preferred shareholders get (in their minds) “made whole” whereas the founders and other common shareholders get screwed, err. diluted.

And it is extremely unlikely that anything can be done. Anti-dilution and liquidation presences are the two mechanisms that VCs use to increase their effective shareholding.

And most founders don’t understand the implications:

  • Whereas a down round may be temporary and the following round may be a BIG up round, there are no provisions to reverse the allocation of additional shares.
  • The shareholding is not impacted (other than for ESOP or convertibles), only the value of the holding at that time … so rather than focus on CURRENT value of investment, stay focused on returns from exit.
  • [Non-Unicorn] Founders are forced to concern themselves with this illusion rather than adjust to reality of valuations that go up and down. Although an imperfect analogy, APPL market cap (i.e. the valuation of a public company) has ranged – in the the past 15 years – between $3B and $1T. Investors still buy stock, even if the price goes down, and don’t expect to be issued more if they are hold a temporary capital loss.

What can you do? Nothing at all until you get past bumper sticker understanding … and even then, perhaps nothing.

Startup as Orchestra. CEO as Conductor.

Startup as an Orchestra

Let’s start with the bloody obvious … startups are hard, and messy, and risky … and many times a cacophony of discordant noises..

So, as CEO, don’t make it harder than it already is.


Sit down, I’ll explain.

The great majority of startup founders are techies – no DIRECT sales experience, or finance, or HR, or, or, or. In fact, most founders are deep in a single domain or function, and – if somewhat rounded – will be familiar with the other, either as collateral osmosis, or from the oracle that is Google.

And, because as a founder you are hard core type-A, you’ll likely want to deep dive into sales (if you’re a techie) or development (if you’re not a techie).


Let me explain that … DON’T.

Whether you are the CEO of a F-10 company, or of a pre-revenue startup, think of yourself as the conductor of an orchestra, NOT the lead violinist.

Do you think Leonard Bernstein (he was the conductor of the New York Philharmonic) – a pianist – Googled YouTube for tutorials on how to play the violin? And if you are a developer turned CEO, don’t think you need to learn how to become a violinist. But what you DO need to learn is how to conduct:

  • What are the range of sounds and emotions that a violin can create?
  • How do those sounds “play” with the sounds of the cellos, or the timpani?
  • Can my lead violinist create the full range of his/her instrument?
  • Will the violin section sound as one, or will the third violinist always get late to their score?

Or course it helped that Bernstein was an accomplished pianist, but he became a world-renowned conductor because he knew how to deliver the capabilities and emotions of every instrument in a composer’s creation, to produce a symphony.

I trust the analogy is gob-smackingly obvious.

Founder Friendly Term Sheets: Liquidation & Participating Preferences

Most founders get their experience on term sheets from the deep-end training on their first. And many, perhaps most, get screwed – without even knowing it. Let’s talk return preferences: Liquidation and Participating.

Liquidation Preferences [LP]: a multiple of a VCs investment that will be return to the VC, before anyone else gets anything.

Participating Preferences [PP]: describes how the VC shares in the returns left after they have taken their Liquidation Preferences.

Taking both is generally considered double dipping. Ten years ago, Northern Ireland had some of the most egregious preference terms I’ve seen. Perhaps today its fairer.

Back in the 80’s – that’s as far back as I go on term sheet stuff – the intent of these terms was to give financial preference to the VC when the exit was not big enough to meets the generally accepted IRR that would be needed to satisfy the funding Limited Partners. Somewhere in the late 90’s, it became a means of taking even more from the founders. And while most founders can conceptualize this, and perhaps even consider it as a cost of doing business, there is a better way.

But first, let’s illustrate the depth and nature of the screw, by way of an example, with simple numbers to make the math more accessible,

Take a £500K Series-A investment, at $1.5M pre-money and x3* Liquidation Preferences and full, non-capped Participating. [* I’ve seen an NI term sheet that has x5]

[If you don’t understand that previous sentence, consider yourself the perfect mark for this screw.]

And, again to make the arithmetic easy, Let’s say the exit valuation is £20M.

So, the VC owns 25% of the company post-money … and to keep things simple, there are no further rounds, and hence no dilution.

At exit, WITHOUT LP & PP terms, the VC gets 25% of £20M = £5m … an attractive x10 of their investment.

Now factoring in LP & PP. The VC first gets x3 of their investment = £1.5M, then then 25% of the remaining funds (25% of (£20M – £1.5M) = £4.625M) for a total return of £6.125M. That’s a x12+ return to the VC, and 22.5% better than the £5M.

But that still not the ‘eyes wide open” way to look at this. To get £6.125M return from a £20M exit … without LP & PP, the VC would need 30%+ ownership.  With money-in of £500,000, that equates to a valuation of ~£1.132M or ~25% less than the pre-money valuation of £1.5M you THOUGHT the VC had agreed to. 

What you don’t know really can cost you.

But, a simple change to the LP & PP terms can rectify this.

Liquidation Preferences of x1 the investment amount shall first be returned to the investor, provided that the total amount returned to the investor is less than x7 the investment amount.”

Investor shall have the option of taking their Liquidation Preference, or fully participating according to their share ownership, but not both.

Hunting Unicorns in Northern Ireland

1999 was the year the tide of the bubble ebbed, when people stopped writing and reading fantasy articles about that myth – I happened to be apprenticing in VC in NYC at that time, it was wondrous.

Twenty years later, and the tide is turning on another fantastic beast, the mythical unicorn … an investment that is SO big, it consumes all who chase her … the UNICORN HUNTERS.

And like the best fantasies – Harry Potter, Lord of the Rings, Game of Thrones – without caring to analyze, we are unconsciously attracted some empirical truth that forms the basis of the myth.

And so, it is with unicorn investments. Look at the numbers.

In successful VC funds, only the top 25% return anything like a risk adjusted IRR, and of those, 6% of their investments in portfolio companies contribute 60% of the returns. For the masochists reading this, I have the spreadsheets that model VC fund performance.

For Northern Ireland with a (say) £20M fund, aiming to get in the top 25% of performing venture funds (which AFAIK has NEVER been accomplished) a PRE-REVENUE startup that shows £50M revenue in year six is an NI unicorn.

The ALGEBRA only needs a revenue of £25M, but the ALCHEMY says that NO-ONE ever makes their forecasts – especially at pre-revenue stage, so we discount tit by 50%. And of course, the ART is the ability to spot the unicorn from the Cerberus. And if you want to call that investment that makes the funds a unicorn, that’s OK.

So, for any intrepid unicorn hunter, the target of the hunt (in Northern Ireland) is a pre-revenue company, showing a 100% inflated revenue of £50M in year-6, looking for £250K seed on a pre-money of £750K .

.. and you’ll never bag a unicorn if you don’t get in the hunt.

Value in Investing in an Venture Fund …

Selling is the willing exchange of value

In the product or service space, those have value to a buyer [your customer], and, in return, the value you (the seller) gets is … money.

In the investment space, whether it’s a deposit in a bank, a mutual fund, or …

a direct investment in s startup, or as a Limited Partner investing in a venture fund, the same applies.  You give a startup or venture fund some money, after some time they give you some back. But how much represents value?

Well, for starters, you’d expect returns that are commensurate with the risk you’re taking. For the past 50 years, investing to stocks, through the S&P500, would have returned you 8%. And an investment in a single business, or even a portfolio of ten or twenty companies, is certainly riskier, and deserves much higher returns. Thirty years ago, the target IRR for venture funds was 20%-22%. Today, 12%-15% is a common minimum. But only the top 25% of funds achieve this minimum.

So, when looking at the value you’d get from an investment, in a venture fund, there are only two answers you need: (1) what IRR* will they return, and (2) what do they have that will put them in the top 25% of fund managers?

*And if they answer in multiples, run …. you are dealing with ejits.

I Shoot Cats

Well, the photo should give it away … PHOTOshoot 🙂 But the back story.

At the turn of the century, Leigh studied photography at the [then] Academy of Art in San Francisco. At that time the industry was transitioning – irreversibly – from film to digital, so she shot with a Nikon N90 (film) and Nikon D1 [its first professional digital camera]. I was basically her bag boy, but got play with Photoshop [the VERY early versions] as she did post-processing.

That turned out to be a really smart pairing … she was an artist behind the lens and a genius – at lighting – in the studio.

Eventually, almost a decade later, when we started our kitten nursery, we turned a garage into a photographic studio – specifically to shoot kittens for their adoption pics. Leigh was far too busy saving lives, supporting fosters, and doing adoptions, so she let me get back behind the lens.

With our studio equipment from San Francisco, THE most adorable subjects [see later] and no deadline pressure, I was in HEAVEN. Over six months I researched, studied and experimented shooting kittens. Eventually developing a workflow and protocol that produced some VERY appealing images.

I learned two things that would help anyone photographing kittens:

  • they move randomly, but mostly directly at the camera as you press the shutter release, which REALLY messes with good focus, so bright lights, fast lens and [if possible] a tripod, are essential
  • the “money” shot is their eyes looking directly into the lens – and hence directly at the viewer – but I found that – whereas it took take 15-20 mins to get just the right head-on shot, it looks less than 60 seconds to realign their little pupils to forward looking in Photoshop. If you’ve ever seen anyone of my adoptions or going home images, probably 60% have post-processed pupils 🙂

I’ll never tire of shooting kittens, or even our family seniors.


Leigh and I are fortunate in life. Our collective bucket lists are almost bare … to see rhinos in their natural habitat before humans extinguish them and the aurora borealis before it fades … and we have found and embraced purpose that fulfills us – both individually and together.

So why this blog?

Well, like many, we have both pursued happiness and peace through quick fix bumper stickers, e.g.

  • “what other people think of you is none of your business”
  • pursue your dreams, not a career
  • etc.

But it wasn’t until our cat* – our first together – died – over a decade ago, that the cosmic tumblers clicked, and we both experienced a quantum shift in our alignment with the universe. Things that are intrinsicaly important came crashing into our reality. We started on our journey of animal welfare, subscribing to the truths of Buddhism (and for me non-theism), veganism (albeit still slightly imperfect) and the inseparable link between love and giving.

This blog is our vehicle to share that journey, those experiences and our re-invention. No preaching, just storytelling.

*Poodie’s ashes are buried under a jacaranda tree, on a beach, off Manda island on the east coast of Kenya. This is near the island of Lamu … the oldest continually inhabited town, and was one of the original Swahili settlements along coastal East Africa. It is believed to have been established in 1370. It is also the home of hundreds of community cats with the closest genealogical ties to the original Egyptian cats gods.