How can you compare convertible notes and preferred equity?

3 Pros and cons for founders

Both convertible notes and preferred equity have advantages and disadvantages for founders. Convertible notes are usually faster and cheaper to negotiate and close than preferred equity, as they involve less legal documentation and due diligence. They also defer the valuation of the startup until the Series A round, which can be beneficial if the startup grows significantly in the meantime. However, convertible notes also carry the risk of default and repayment if the startup fails to raise a Series A round before the maturity date. They also dilute the founders' ownership when they convert into equity, and may create misalignment of interests with the note holders, who may have different expectations and incentives than the founders.

Preferred equity, on the other hand, gives the founders more certainty and clarity about their ownership and valuation, as they are determined at the time of the investment. It also aligns the interests of the founders and the investors, as they both become equity holders with a common goal of growing the startup. However, preferred equity also comes with more complexity and costs, as it requires more negotiation and documentation of the terms and conditions. It also gives the investors more rights and preferences over the founders, which can limit the founders' flexibility and autonomy in running the startup.

4 Pros and cons for investors

Investors also have to weigh the pros and cons of convertible notes and preferred equity when investing in startups. Convertible notes offer investors more flexibility and optionality, as they can choose to convert into equity or get their money back with interest. They also give investors a lower entry price and a higher upside potential, as they can benefit from the valuation cap and the discount rate. However, convertible notes also expose investors to more uncertainty and risk, as they depend on the startup's ability to raise a Series A round and the terms of that round. They also have less control and information over the startup, as they are not equity holders yet and do not have the same rights and preferences as preferred shareholders.

Preferred equity, in contrast, gives investors more security and protection, as they have a fixed ownership percentage and a liquidation preference. They also have more control and information over the startup, as they have voting rights, board seats, and information rights. However, preferred equity also requires investors to pay a higher price and accept a lower return, as they do not have the valuation cap and the discount rate. They also have less flexibility and optionality, as they are locked in as equity holders and cannot easily exit or change their position.

5 How to choose

There is no definitive answer to which option is better for startups and investors, as it depends on various factors, such as the stage, traction, valuation, and growth prospects of the startup, the availability, appetite, and expectations of the investors, and the market conditions and dynamics. The best way to choose is to understand the trade-offs and implications of each option, and to communicate and negotiate openly and transparently with the other party. Ultimately, the goal is to find a win-win solution that aligns the interests and incentives of both founders and investors, and that supports the long-term success of the startup.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?