This one is pretty law geeky, so stay with me.
When you go to raise money for your company, you have to decide what you are going to give your investors in exchange for their cash. Your choices are usually a promissory note (if you call the cash a loan) or equity (if you call the cash an investment). There are also a few hybrids of debt and equity. One hybrid is the convertible note.
If you give a convertible note, you say to the person who gave you cash, “I’ll pay you back. But, if my company grows, I’ll pay you back in equity rather than cash, so you’ll stick around as a part owner in my company.” In the beginning, when startups need cash desperately, they are often led to give a convertible note – for many reasons – but principally because it’s treated as a shortcut around expensive legal work. It’s not a problem if things go badly for the start-up, but it begins to pose one if things go well.
If things go badly, either the investor gets paid back or the company dies. But, if the startup blossoms, then you have to give him a fair amount of equity in place of paying him back cash with interest. And, you probably have new investors attracted by your success who complicate matters.
Here is an article pointing out 7 things that can go wrong with convertible notes. I’m not sure I love the writing of this article, but I love the sentiment. The fact is, raising money for a company is complicated and hard – it is up to corporate lawyers like me to make it – not simple – but navigable. We are making progress, but we aren’t done yet.