Venture Capital

An Insider’s Guide to Convertible Debt vs. Equity'

Jason Lemkin

In the annals of Blog Posts About Things I Don’t Care About, Convertible Debt versus Equity is high on the Top 10 List. It’s not higher than How to Have a Great Bored [sic] Meeting, but it’s high up there. I mean, whatever, right? All that matters is investing in great companies at a fair, stage-appropriate price, right?

Yes.  And as an angel, we can end and stop right there.

But …

Now that I’m a VC with a few good investments — and a few mistakes — under my belt, I’ve learned it’s not quite that simple.

The other day, I got a good reminder.  I’d made a relatively small ($800k) convertible debt investment in a company, and the VC that led the round then rewrote many of the terms.  He cancelled the stock option plan and outstanding grants to change the effective price.  He manipulated the way participating preferred worked to game the system.  And he attempted to amend the existing notes and play favorites vs. those who didn’t sign up for the amendments.  And did it without any notice, and by excluding all the existing shareholders from any notifications, board meeting notes and minutes (even those with contractual and/or legal rights to them).

And it all worked.  This VC got everything he wanted.  Kudos, dude.  I mean, I’ll never recommend this VC firm.  But they are doing just fine.  Just fine.

So even as a VC now, I realize it’s not totally an academic debate.  But even in this case, it’s not that big of a deal.  It was a small investment relative to whole size of the fund.  And we probably won’t lose money in the end.  Whatever.

I-Always-Pay-My-Debts-gehrIn a different company, the other day I was also sent a bunch of, uh, aggressive convertible debt documents in another potential deal.  The terms said the investors would get (x) no share of any gains from an acquisition that occurred before conversion to equity, and (y) worse, the company could buy out the investors for $1 on the $1 any time before conversion.  At least on paper, that meant if I and others invested at $1 and in 18 months, VCs offered $5 in a Series A or an acquirer offered $10 per ‘share’ to buy the company … the company could buy us out for that same $1, with no gain, and just return the capital.  I’m all for being founder-friendly, trust me.  But this seems kinda unfair when you’re taking huge risks here.  Even Snapchat didn’t ask for this in its last common stock round at $16 billion.

You can laugh, and say hey, that’s nonstandard.  You can say you don’t see that in a YCombinator SAFE (which you don’t), etc.  But Wilson Sonsini drafted the docs, so those terms can’t be THAT nonstandard.  It can’t be the first time.  Just my first time.

So anyhow, from all this I’ve synthesized a simple set of rules (and then let me tell you why next):

  • If my investment < $1m, then
  • I don’t care — any docs (within reason) are fine; BUT
  • Just so you know — I won’t care quite as much as if it were equity.
  • And if investment > $1m from me, and >= $2.5m overall, then only standard, founder-friendly Series Seed equity docs work for me — or I’m out.

Ok.  Why’s this the rule?

Here are the PROs of Convertible Debt, SAFE notes, and the like, at least the ones that matter, as I see it:

  • Fast & easy.  It’s true.  Although this isn’t just because the documents are simple.  You can draft very simple Series Seed equity documents.  Convertible Debt / SAFE are also fast & easy because no one does any legal (or often, any other) due diligence.
  • Any amount is fine.  You can do another SAFE for $50k anytime you need it, no biggie.  This is very valuable in the early days when you are capital constrained.  Just throw another shrimp on the barbie when you need one.
  • Cheaper.  This is true — at least for now.  Legal fees are far smaller, although in the long run, will cost you more (because you are really kicking the can on issues), though that may be OK.  It will cost you $20k-$50k in legal fees to do an equity round.  Doing this if you are raising < $1.5m makes little sense.
  • Zero control given up.  You give up nothing.  The debt/SAFE investors don’t even get a basic vote on anything, no matter what they invest.  Because they aren’t even shareholders, not yet.  Not until it converts to equity down the road.
  • No one knows, or sweats, percentage ownership.  This cuts two ways, but since you can issue unlimited notes on any schedule, no one really knows how much they are buying.  As a founder, you may end up giving up far more of your company than you realize, but maybe even that’s OK if you can ignore it 😉
  • As a VC/investor, sometimes I can get a slightly better net deal on price at least.  Founders don’t really understand how all this works.  If I invest at a $6m cap, and you then issue a ton more stock and add a large option pool — and then raise equity 18 months later and I still get a $6m pre-money then, I “win” (I guess).  Because I don’t have to suffer any of that dilution.  All things being equal, a VC and investor may be able to get a slightly better deal with convertible debt.  But it’s nickels and dimes — personally, I don’t care.

Here are the CONs for me (some are general, some mainly apply to me as a VC).  Some you may not care about, but at least you’ll know:

  • I won’t care as much.  Here’s the thing.  If I invest as a VC in convertible debt, and I don’t know what the terms are (they are set later), and I don’t know how much I own (who knows how much you will sell, and how much I’ll own), and the Next VC can just change all the terms anyway (see example above) … I just won’t care as much.  Maybe I got a good deal on price, but if the investment ends up being immaterial … then it doesn’t matter.  If I don’t know what I’m buying or how much, I just don’t care as much.  Being honest, I’ve worked harder for the companies I’ve bought equity in vs. the ones I’ve invested in via convertible debt or SAFE.  You may not care — it depends on what help and engagement you want.  But it’s not just me.  Many start-ups are filled with VCs who bought 1% or 2% or 4% of a company in a SAFE and have never been involved at all, and end up dead-wood on the cap table, and maybe at the margin — a negative signal in the next financing round.  If it’s so great, and Andreessen invested, why aren’t they leading the next round?
  • Bad corporate governance.  I never ask for, nor want, nor care about, control.  I was a 2x founder CEO.  Basically all the VC term sheets I’ve written just say “+1 Board Seat representing All The Preferred Stockholders” or something similar.  But what I’ve learned is when no one is on the board, mediocre things happen.  Accountability matters.  And in the end, the board should be roughly structured proportionate to ownership.  If you are selling 20% of the company, VCs can have 1 board seat, you can have 4.  Or whatever.  But if there is no one representing the folks that have taken real risk investing in you — that’s just a bad recipe.  I’m out, in any event.
  • No legal diligence.  An ex-founder that actually owns 20% of the company you forgot to tell me about?  You promised 15% of the company to someone?  The legal entity I signed the notes with isn’t actually the company I thought I was invested in, but a related entity?  You’re taking $150k out of the SAFE proceeds to “pay yourself back”, but didn’t tell anyone or disclose it?  This happens, guys.  And it’s not funny.  With convertible debt and SAFE, no legal due diligence is done.  If nothing else, it adds to my stress load, especially because I like to do business on a handshake.  I don’t want to have to do this diligence myself.  I want to make an initial decision in 20 minutes.  So this Con turns out to be High Stress and a Big Bummer.
  • You are incurring legal debt along with your convertible debt.  This isn’t a huge deal, but if you do 4 rounds of SAFE notes at 4 different prices, there will be legal debt to sort out later.  Not huge deal, but in the end, you aren’t saving money doing convertible debt.  Although your cost of capital will fall.  If money incredibly tight, you’re better off having a cleaned up company now.  It’s just gets more and more messed up as time goes by.
  • I don’t know what I’m getting — terms and ownership.  This is related to the first point.  Debt/SAFE is efficient in part because The Next VC figures out all the legal terms.  That works out fine when we all have the right checks and balances.  But sometimes, The Next VC does what’s best for Him.  And sometimes that’s throw the early guys, just a little, under the bus.  I won’t do it.  But it happens pretty often, although not most of the time.  This just adds to my stress as a VC to not know what’s coming.  So I, maybe even subconsciously, don’t buy in as much.  Because I don’t really know what we shook hands on, not really.  Almost.  But not really.

What I don’t care about that other people do in Convertible Debt vs. Equity (and that you’ll hear a lot about on the Internet):

  • Acqui-hire drama.  There can be big differences between convertible debt and equity in acqui-hires, at least in theory.  But I’m not investing in anyone going for this outcome.  So whatever.
  • You have to pay convertible debt back (allegedly) at expiration, pay interest, etc.  Whatever.  Who cares.  Nickels and dimes.  Maybe even pennies and nickels.  I’m not in this for 5% interest.  Keep it.
  • M&A before next / first real venture round.   All I care about is something fair.  Here’s where VCs can definitely, in fact almost always, do “worse” with convertible debt vs. equity.  Not an acqui-hire but a real, but small acquisition.  Whatever, again.  Nickels and dimes.  Don’t care if you sell the company for $20m, if that’s what you want to do.  Go for it.

So net net, the Internet makes too much of all this.

But I want to do business on, and as if on, a handshake.  To do that, all I want is:

Stronger-than-Oak1#1.  to own X% for $Y, and to know I own X% for $Y;

#2 .  for there to be basic good corporate governance in placesomeone on the board to represent investors who have, after all, risked millions of dollars on not much more than faith in you and a handshake; and

#3.  I just want to know that basic legal diligence has been done to ensure it really works the way it should.  That I am really getting X% for $Y.

>> And I just can’t get those 3 things (and therefore be comfortable on a handshake) with Convertible Debt or a SAFE.

So if it’s a $250k or $500k or whatever investment of that size, just send over whatever documents you have.  Anything is fine on a fair price / cap.

But when the check size crossses $1m, and/or the total invested in the round crosses $1.5m — I’m just out if it’s Convertible Debt or SAFE.

Life’s too short for this type of stress, and to not be able to do business on a metaphorical handshake.

There’s always another investor, though.

Published on June 1, 2015


  1. The problem with the whole thing is that an investment (debt, equity, whatever) is made by both parties based on the information available at the time of investment. For that reason, it should be obvious to all that equity is best — since the unknowns are huge. Those unknowns become knowns and a series A is set and folks with debt can get a big bonus (if the company does great in getting a high Series A valuation) or lousy (vice versa). Therefore, the ONLY fair thing is for complete alignment….agree on a valuation based on investment-time-available information and move on. This, at once, eliminates things that wrongly favor investors OR entrepreneurs. Series Seed is a great way to do this.

    1. I’m with Will on this one; this firm should be called out. You can tell me and I can call them out if you’re sensitive about it.

  2. Hey Jason,
    Thanks for the great post(s). I would really love to read a post from you analyzing Buffer – as it has all its sales data public on their dashboard site. They seem to be growing fast (although far slower than what you call hyper-growth) and I think it would make for an interesting read on what you think of their metrics and growth. Keep up the great content!!!

    1. Well, I believe the Buffer founders are A+ / excellent and am paid customer as well. So I am a fan. Also, I am 100% convinced they’ve traded off even faster growth by sticking to a freemium model. I think they agree, so it’s a pretty interesting “lifestyle”, or really, “company-style” trade-off. Do you want to be like 37 Signals or Automattic? Or do you want to end up like Salesforce? We all sort of want to do the former, with the ARR of the latter …

  3. Great post, as ever, Jason. Thanks! Of all the many posts I have seen about Convertible Debt, yours was actually the first that recognized that it avoids dilution of the angels upon the sale of stock in the next round and the establishment of an option pool.

    1. That’s because everyone has an agenda. VCs have an agenda, Angels have an agenda. So they put a spin on everything. I don’t care personally, I just don’t want the stress of convertible debt if the amount is too high 🙂

  4. You’ve written a killer article, Jason. Good details here which help fill in a lot of holes. This is the first column of yours I’ve read. Now I’m a fan.

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  6. This is a great article because it goes beyond the typical legal description and gets into the motivation of the investor behind the points made. I appreciate the transition to being a VC vs. Angels. For angels who do this full time (vs. VCs who jump into angel deals for fun) maybe the arguments for equity are stronger. Nobody talks much about the tax benefits of equity, but it’s pretty much a guaranteed 20% greater ROI because of the tax breaks available to angels. Here’s a post with some thoughts on this.

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