Revenge of the Convertible Note – Part 2

Gil Silberman , Gust Partner , Luca Ventures

19 Aug 2024

This post originally appeared on Gil Silberman’s Blog.

Startup investors get screwed either way… and I like it.

TDLR, the new Angel Capital Association model convertible note form rates 🦄🦄🦄🦄 ½ – four and a half unicorns., a winner!

Real investors don’t want to lead a SAFE Note or convertible debt round. Thats why we don’t talk to each other.

Part I Redux

Lots of early stage non-professional startup investors out there know a guy who knows a guy who lost their entire investment when an unscrupulous founder screwed them out of the benefits of their SAFE note or other non-equity instrument. Because they could. Because these investments are just contracts, lacking the most basic of investor rights and legal protections that come automatically when you own stock.

Last week I argued that angels shoot themselves in the foot by insisting on preferred stock rounds – optimizing for pushover founders who will accept a harsh deal because they’re desperate or uninformed, rather than chasing the rare rock star founders who stand up for themselves and won’t go for a VC-style transaction before they’re ready.

What I didn’t say is that I think the investors are right, legally speaking. It’s just that doing it right and making money are often at cross purposes due to the power law of investing and other practical and statistical realities.

As a result, SAFEs are currently the way to go per Peter Walker, Head of Insights at Carta. They’re used for the vast majority of US pre-seed and seed stage startup transactions all the way to $5 million as of Q124.

In my opinion SAFES are the best way to go for investment rounds of under $1 million, and perfectly adequate for lack of a better option all the way up to about $4 million unless you are an active, experienced full-time angel investor and leading the round either as head of an angel fund, syndicate, or angel group that bands together. Or you’re putting up $4 million yourself or through a family office, in which case you are definitely not an angel and it’s time to get more serious about investing. In all these cases it’s time for you and the company to bite the bullet and do an industrial-quality priced equity round.

If only there were a better way, a fast, lightweight set of standardized, industry approved documents that angels could trust to get them the rights they need without shifting all the onerous risks to the company. My final argument last week is that this is an optimization problem of bids and asks, not one of getting the upper hand. Instead of dialing contract structure and sundry clauses up or down on the sole issue of investor rights, it’s best to adjust multiple things at once to find a solution that makes a collective surplus to both founders and investors. Then they can argue on the price, knowing that the terms are fair to both.

Enter the Angel Capital Association‘s New Convertible Note

Last week I got wind that fellow Startup lawyer and Princeton classmate Dror Futter was working with a team of investors and lawyers on a modernized, standard, industry-approved convertible note that would be released imminently by the Angel Capital Association.

Sure enough, it was announced a couple days ago on the ACA blog.

I was more than a little skeptical that an East Coast-centric group with relatively little representation from the various Silicon Valley mafias and other actual startup founders would produce a sensible document reflective of market realities. I went on a rant about GAAP financial requirements, one of the most ridiculous pretenses that lawyers put into funding documents, seemingly unaware or not caring that startups are not capable of doing that.

But guess what? I read through several times from start to finish, made notes, thought through the implications, and it is very, very good – better than the forms used to date by the top venture capital law firms. So, bravo.

A solid A-minus, here’s my quick take.

I’ll be diving into the details in Part III and however many it takes, but in the interest of getting it out there, here is my quick take.

The good

• It is very well drafted.
• They caught and solved 90%+ of the bugs and major points of failure common to nearly all convertible notes to date.
• It works. You should use it for any round from $2–5 million, and it’s perfectly acceptable for rounds as low as $500K
• The structure is modernized, mostly, to fit current trends in investing and legal document construction.
• It promises to become an industry standard, which will make seed and pre-seed funding more reliable, transparent, and cost-effective than before

The Bad

• It’s too damn long – 16 pages, not counting an 8-page term sheet.
• It’s confusing to non-lawyers. Even I had to read it a few times to fully understand how everything fit together.
• It’s fidgety, reflecting an irreducible complexity that comes from designing documents by a committee determined to add so many things into the agreement to protect investors and founders alike.
• Some terms are unrealistic – yes, it calls for seed stage companies to give GAAP compliant financial statements to their investors.
• The reps and warranties are more than a company could fairly promise, which means back-and-forth over a schedule of disclosures and exceptions, something that usually leads to investors demanding a corporate-cleanup before they will invest.
• The term sheet is just awful, a C plus. It is wholly unnecessary, full of trivial points, and leaves out and seemingly contradicts some very important fine print in the main document. I would just leave it out and start with the definitive agreement.

The Ugly

• Don’t try this without a lawyer, a good startup savvy one who knows how to deal with convertible notes. That’s for companies; an experienced investor may begin to minimize legal costs after the first few go-throughs.
• It will cost you – my guesstimate of all-in legal fees is $10–20,000 despite the standardization.
• You can still get screwed as an investor unless you’re the lead investor. In fact, practically, I don’t think it really solves the most common way this happens.

That’s my version of praising a legal document. I’m picky. This is just the first release, and I can tell you from my own experience running law firms and legal departments that the first version of any legal form document always leaves room for improvement.

In fact, I think this will move the needle so that this convertible note, not SAFEs, will be the standard for every round upwards of $2 million funds raised, until companies are ready to prepare for growth stage and career professional investors from micro-VCs and other institutions step in at the seed or Series A level.

It’s good enough that I’m encouraging Gust Launch, an online corporation-as-a-service platform and founder community, to develop an automated version as soon as possible so we can promote it as a best practices way to raise money – and to reach out the ACA for their blessing.

To honor the standardization process we won’t change a word. I’ll probably write a universal addendum / side letter that addresses the very few technical flaws and bugs they haven’t fixed yet (more about these in coming posts).

Kudos page

Many thanks to the following ACA task force members who made this real:

• Elizabeth D. Sigety, Esq. — Fox Rothschild, LLP and Delaware Crossing Investor Group

• Mark Friedman — RTP Capital

• Dror Futter (mentioned above)

• Sonu Mirchandani — College of Business and Technology, ETSU

• Clay Rankin — North Coast Ventures

• David Sikes, Esq. — Goodwin Law

• Joe Wallin, Esq. — Carney Law

• Ronald Weissman — Band of Angels

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