Convertible Note Conversion Discounts

I passed on a deal this week because the terms were bad.  It was a seed stage deal, I like the entrepreneurs, the technology was cool new stuff invented in a university, and they seemed to understand the landscape well enough that I was willing to break my "no pre-revenue" rule and my "no hardware" rule.

The deal breaker was the convertible note terms.  The typical convertible note deal (for Boston in the past couple of years) has 2 terms: an interest rate and a conversion discount.  The note for this company had a single-digit interest rate and no conversion discount.  If you spend 10 minutes with a spreadsheet to compute the post-money valuation of your investment, you can determine that the discount is the main incentive to do this kind of deal.  A convertible note without a discount would have to carry an interest rate of 20%-30% to make up for it.

When I asked about the lack of a discount, they told me they had their agreements done by a Silicon Valley law firm, and this firm strongly advised them to not offer discounts since A-round investors would push back on the discount and make it harder to raise the next round.  I explained that without the discount, there was no risk premium to justify investing now versus investing later.  Their hands were tied since they had already closed money under these terms, so we parted ways.

So now I really want and need to know if A round investors make a practice of crushing convertible note investors like this, or if this is an echo of deals done after the dotcom crash?  Were the entrepreneurs poorly advised by their law firm? Or are Angels just fodder for follow on investors?


Quick Hits

H.R.4213 American Jobs and Closing Tax Loopholes Act of 2010: The House of Representatives is taking another shot at taxing Carried Interest as regular income.  I don't see why this is controversial.  Carried Interest is not Capital Gains.  If you want Capital Gains tax treatment, you should have actual Capital at risk.  Trying to argue otherwise is disingenuous.

I'll be at the Angel Bootcamp in Boston on June1.  It doesn't sound like a regular bootcamp; it starts at noon instead of 4am and I don't expect to have to do any pushups.