We're concerned about the pervasiveness of convertible debentures in the startup community. This is a position piece in support of that idea.

1. There may be cases when the use of convertible debentures is justified. Such instances include companies able to generate operating cash flow relatively early on and specifically before their
debt matures. Note that we distinguish here between revenue and cash from operations, as the presence of revenue does not automatically equal profitability and does not always put your
business in the position to start repaying debt.
Most Pre-Revenue Deals Should be Priced Equity Rounds, Not Convertible Debentures
By Sanford Diday & Victoria Yampolsky, CFA
- Initial Investment Structures are Critical Building Blocks -
We all know time is money, but taking the wrong kind of money at the wrong time can be crippling. We think everyone
needs to stop, take a deep breath, and think carefully about their role in the startup ecosystem.
Business fundamentals rest at the core of our beliefs. We counsel lots of early stage companies and, as a rule, we
challenge ourselves to remain critical of the status quo with hard analyses to make us better in all we do. For this piece,
we focus on how choosing between convertible debentures and priced equity rounds can affect investor confidence,
company growth, and founder dilution.
JrPixels, the Startup Station, and their principals have been consulting, advising, investing in, and working with startups
and growth companies for over twenty years. Each new deal goes through a similar process, and we begin each with
some basic truths in mind. Good fundamentals build good businesses. Do things the right way the first time, and you can
avoid a lot of costs and headaches in the future.
The logic of executing well on fundamentals is nowhere more prevalent than in the financing process. In our experience,
the importance of financing as part of company building is often lost on founders because they don’t have the necessary
expertise to understand it well. Many founders think they don’t need it at such an early stage. That is a mistake.
Because of the weight financing carries throughout the growth process, attempts to hack this process with quick, poorly
structured deals may put your company at great risk.
Nowhere do we see a need to sound the alarm more than with early funding rounds, specifically as it relates to the use
of convertible debentures as a financing vehicle for pre-revenue companies. Historically, convertible debentures were
not designed for pre-revenue companies. They were designed for revenue-generating companies to reduce their cost of
debt while maintaining the tax benefits from interest payments. A call option (the convertible feature) on the company’s
stock is a form of compensation to debt investors for the reduced coupon and is a way for them to participate in the
upside when the company does well.
Generally, we recommend all pre-revenue companies create a pro forma financial model and do priced equity rounds.
We did this with great success with Opkix, InPerson, Change My World Now, and others within the last year.
Unfortunately, we’ve seen an explosion of convertible notes in recent years, and we’re deeply concerned.
Our rationale in support of crafting a financial proforma for priced equity rounds is rooted in firm business strategy.
“Why create financial projections when it is all a guess?” We hear this – All. The. Time. Like with the rest of the MVP
process, many entrepreneurs have trouble reducing the uncertainty in which they operate to a limited set of variables
within a structured model. Their mistake is how they define the objective they aim to accomplish.
The goal of financial projections is not to guess the future. That is not possible. Rather, the goal is to define the
company’s business strategy for the next 2 - 5 years and create a mathematical representation of that strategy in the

2. There may be cases when the use of convertible debentures is justified. Such instances include companies able to generate operating cash flow relatively early on and specifically before their
debt matures. Note that we distinguish here between revenue and cash from operations, as the presence of revenue does not automatically equal profitability and does not always put your
business in the position to start repaying debt.
form of a financial model which may then be used as a core piece of your valuation argument and, of course, a natural
guidepost for your priced equity rounds.
- The Unsaid Pitfalls of Convertible Debt -
The U.S. economy used to have a 66% failure rate for new businesses; now it’s ~ 90%. It’s intellectually dishonest to
suggest the reasons for this increase may be summarized in anything short of a doctoral thesis in Economics.
Nonetheless, this fact tells us a lot about the state of the startup ecosystem and provides a clear reason why priced
equity rounds present healthier options than convertible debentures for pre-revenue companies. Also, because startup
investment risk has undeniably risen, investors have additional incentive to utilize complex financial instruments to their
advantage.
We’re not saying convertible debentures are a bad instrument. Instead, we’re saying convertible notes are both
misunderstood and frequently misused by startup founders and investors. You may have read some “industry experts”
say things like, “convertible debentures are designed not to be paid, but convert to equity.” Let’s be clear, that both
obfuscates the nature of convertible notes and is woefully incorrect. Let’s review the classic features of convertible debt.
1) They were designed for revenue-generating companies with the intention of giving them access to lower-cost debt.
2) They are a complex debt-equity instrument with compounding interest + maturity date + conditions on conversion +
preferences + a lot more if you’re not careful (like Full Ratchets, ‘lower of’ VWAPS, and onerous OIDs).
3) The interest coupon is usually a cash payment to investors, made at regular intervals. While these payments may be
deferred until the debt’s maturity, or converted to equity upon triggering events, these features are meant to be
deal sweeteners not primary parts of the instrument.
4) If the principal loan amount plus capitalized interest isn’t paid at regular intervals and doesn’t get converted, then
the total amount (principal + capitalized interest) is due in full on the maturity date.
5) A company must have a formal valuation prior to debt issuance to determine conversion terms.
The inherent complexity of these instruments is far greater than the complexity of priced equity rounds. Specifically, this
complexity may pose a grave threat to your company’s continued operations by creating cash flow pressures (interest and
principal payments) you may not be in the position to satisfy. They may also prevent your company from gaining future
financing via a suddenly expanded capitalization table after a forced conversion.
We think it’s rational to say no one should enter into a contractual agreement they do not understand. After all, you
could wind up with a fox guarding the hen house.
Why would it make sense to load up a pre-revenue company with debt they cannot repay, which creates a ticking time
bomb of a capitalization table with the potential to decrease founder ownership to de minimis levels? We certainly can’t
think of a good reason.
- Dubious Benefits of Convertible Debentures -
It’s faster. Perhaps, but as a result, you may give up a larger percentage of your company later at an unattractive price
for a bit of saved time now.

3. There may be cases when the use of convertible debentures is justified. Such instances include companies able to generate operating cash flow relatively early on and specifically before their
debt matures. Note that we distinguish here between revenue and cash from operations, as the presence of revenue does not automatically equal profitability and does not always put your
business in the position to start repaying debt.
It allows me to jam investors in quickly and provides more flexibility with regard to whether I’m an LLC or an Inc. So,
you’re saying you don’t want the right investors, but instead want fast money that may not be right for your company?
Additionally, do you mean to say that understanding the correct corporate structure for the needs of your business such
that it supports good corporate governance and the further success of your company doesn’t matter?
Doing an early priced equity round is more expensive because it requires me to do more financial and legal work.
You’re right; it is more expensive. However, doing this work provides a more thorough view of your business model
combined with a solid financial model so you can have realistic valuation discussions with potential investors. Doing this
work will enable you to lay out concrete near-term goals for your company as well as a salient strategy to hit those
targets. You will also be able to evaluate which human, infrastructure, and financial resources are required to launch and
scale. Further, you’ll identify when you can expect to see revenue, break-even, and enjoy profits. What's more, this
analysis will organically determine critical company milestones which guide the timing of financing.
It reduces transaction costs. Sure, but again, the cost savings are not enough to make up for the potential loss of equity
and control of the business.
You see where we’re going with this? Long-term thinking is always a beneficial exercise, and long-term planning usually
wins the day.
- Fundamentals Matter -
Here’s the deal: investing in companies is about aligning the economic interests of the company with those of investors.
Priced equity rounds on pre-revenue companies support this basic tenet; convertible debentures, generally, do not.
Likewise, it follows that it’s best to value pre-revenue companies using their own business and financial fundamentals
rather than an arbitrary valuation (or valuation cap) taken from a so-called comparable that qualifies as such only by
virtue of it being in the same industry. That is especially true when those “comparables” have different business models,
products, and growth strategy, and therefore have nothing to do with the company being valued.
Founder marginalization is potentiated with convertible notes because the deal terms don’t include the right to invest in
future rounds (Do you want a one-time investor?) as well as a set of information rights that spell out the rights and
conveyances of all parties. Both features are typical of seed equity instruments, and when absent, may increase the
likelihood of a host of problems, including 1.) Confusion about the precise nature and meaning of the verbiage outlining
the legal rights conveyed by the convertible debenture agreement, 2.) An expanding investor pool at later financing
rounds that may not agree with the legal language, and 3.) A litany of capitalization table issues that distribute decision-
making power between increasing numbers of entities.
When convertible notes are misused, and conversion is set as a primary feature, there is a misalignment of incentives
between investors and founders; not to mention pricing confusion in the marketplace. This applies especially to
debentures without caps and discounts. It goes without saying that founders want to move quickly to hit milestones
and get to the next round at a maximum valuation they can justify. However, the debt holder has an economic incentive
to get a lower price for the first priced equity round, so she is in a better position upon conversion or sale (remember, the
debt is tied to the equity, so as the price goes down, investor share count goes up). Such misalignment tends not to exist with priced
equity investments because each investor agrees to buy X shares for Y price, which is much cleaner and allows all parties
to know what they own and when. Clarity is always good.

4. There may be cases when the use of convertible debentures is justified. Such instances include companies able to generate operating cash flow relatively early on and specifically before their
debt matures. Note that we distinguish here between revenue and cash from operations, as the presence of revenue does not automatically equal profitability and does not always put your
business in the position to start repaying debt.
As if all that wasn’t enough, convertible debentures remove founders from the immediate responsibility of carefully
managing the capitalization table, which can be deadly. Mastering the math of how investments affect the capitalization
table is essential for anyone growing a company and a categorical imperative if you’re raising money. We presume no
one wants to drop the ball with such a critical piece of business.
To be fair, there is at least one reason to use a convertible debenture in a pre-revenue company, and that’s as a bridge
loan to an appropriately valued predetermined equity financing round. In this case, when structured properly, they
make sense because they remove conflicts of interest between insiders.
Is it possible to structure convertible debt to have the same properties as a priced equity round? Yes. But, if you are
going to do that, why not use the instrument you are trying to emulate, which is easier to understand and structure?
If your company is pre-revenue just do priced equity rounds. Don’t believe the hype. They’re not that hard to execute,
and over the long-term, they better align the interests of founders and investors and help evaluate how successfully you
are executing your strategy. There is no better tool for evincing clear proof points that will define and drive the need for
a higher valuation.
- Conclusion -
Fundamentals First! Make it your motto.
Do your research, build your business strategy, create your financial model to reflect your company’s execution plan,
and then make sure your company’s financial model and business model make sense. Ask yourself if you would invest in
your company. Is the business case compelling enough? Is there enough long-term potential? How confident are you
that you can hit your valuation benchmarks with all the strategic initiatives you intend to put in place?
After you complete these steps, you can create a meaningful business plan deck, executive summary, corporate profile,
and a product outline for presentation to investors.
Do this well, and you radically increase your chances of finding the right investors that serve the growth needs of your
company. Along the way, you’ll glean a much more thorough sense of how your business is geared and what levers you
may pull to execute your company’s go-to-market strategy. As a result, you will be much more likely to succeed because
you’ll be prepared for changes that will invariably come your way after launch.
Don’t forget, strategic planning and execution are everything.
Cheers and good luck!