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How Can a Startup Avoid Being Taken for a Ride by an Investor?by@mrwatermelonhunter
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How Can a Startup Avoid Being Taken for a Ride by an Investor?

by DKNovember 14th, 2024
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Too Long; Didn't Read

Focus on the business, not the lottery.
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In the US system, when investors purchase convertible notes from a startup, the startup issues the shares to all investors simultaneously and pledges them as collateral for each c.n. transaction.

This allows each investor to claim a fixed stake and, importantly, a % of the shares or a fixed amount of the return on the debt instrument.


Let's consider an example of a Seed investment in startup that has released an MVP and attracted some initial clients:
The convertible notes are backed by a 12% equity stake for $3m.

The terms of the notes allow the holder to return the principal and/or convert them into shares at the option of the note holder upon the liquidity event(sale, liquidation, IPO).

Please note that noteholders don't participate in the mgmt of the company and have voting rights only in relation to the sale or any other form of full monetisation of the investment.


Notes are not subject to any trading restrictions in the secondary market.

A monetisation event could be the sale of the company for $25m, in which case the investor would receive their $3m.

If the company is sold for $50m, it becomes a more attractive investment as the stock will be worth $6m.

Conversely, if the company is sold for $10m, it may be beneficial to take on debt, with the investor receiving their $3m.
If an investor takes equity, the entire value of the company is equity.

Conversely, if they take debt, the value of the company is divided into debt and equity, with the remainder being capital to be distributed among the shareholders.

A notes are senior to the Seed notes in the event of a liquidity event - this means that the A notes holders will first make the conversion decision, and then the Seed holders.

Therefore, the LIFO applies to all rounds.

In each round, the investors' shares remain unchanged, but the sale proceeds result in a dilution of the founders' & team's shares.

Founders often have the right to veto all matters except the vote on a liquidity event.
What if the investors were to exert pressure and only agree to a new round at a 2x liquidation preference?

This implies that at the liquidity event, the option is between redeeming the bond at 200% of par value or a block of shares in the security.

Consequently, it's possible that all the notes from rounds B-C-D will be presented as debt instruments, leaving only the backers', Seed and A investments in the shares.


The implication is that the startup game has a deliberately negative probability of a positive outcome with a positive math expectation.

Consequently, it's the median practice that is most worthy of analysis, rather than the "unicorn in 3 years" cases.

Focus on the business, not the lottery.


It’s also advisable to exercise caution with regard to growth, in order to avoid the necessity of having to select 2-3 preferences.

By assigning X's to the note, you're effectively creating a loan at a nominal interest rate!