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Columbia Business School Prof. Ed Zimmerman on How to Avoid Convertible Note Glitches

Startup Founders: Avoid These Convertible Note Glitches

JUL 12, 2016

Unfortunately, one of the biggest mistakes founders make when raising capital for startups is forgetting that convertible notes will actually have to convert. Founders who focus on the simple question of “what will happen when these notes convert?” will likely be spared some pain and suffering when they do their next fundraise. Here’s why.

Ed Zimmerman
Columbia Business School Professor Ed Zimmerman

During the last decade, founders have increasingly used convertible notes as the mechanism of choice for seed funding. Convertible notes help founders and investors sidestep the friction of agreeing on a valuation for the startup. However, using convertible notes to fund a startup entails agreeing that the notes will convert into the next round of funding – this kicks the can down the road forcing the next set of investors to ‘price the deal.’ Note rounds can be shorter, simpler and faster than preferred stock financings. However, if the conversion to equity isn’t smooth, it can cause some real problems. We in the startup world have become so fond of using convertible notes that we overuse them – convertible notes (especially those with “valuation caps” — see the Appendix below) were designed for raising smaller amounts of capital, not multi-million dollar financings. Because we’ve raised the stakes (by using convertible notes in larger fundraises), we’ve also exacerbated some unintended but avoidable problems. Here are two and I’ll reference a third that’s very worth noting.  REST OF THE STORY

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