With seed funding, founders need to accomplish several goals: (1) raise early money as a bridge to Series A to avoid having to take large money right up front when valuation is at its lowest and the dilutive hit will be at its maximum; (2) keep equity incentives priced relatively low so that a quality team can be assembled without giving its members tax grief; (3) keep transaction costs in raising the money reasonable; (4) move to close relatively quickly to avoid getting sucked into the fundraising time sink.

Convertible notes and convertible equity (SAFEs) both allow founders to meet these goals in ways that equity rounds simply do not. In this sense, they have incredible value as tools to be used by an early-stage startup.

Are they perfect tools? Well, no. Each has its own limitations and problems and each can be abused on either the company side or the investor side. Founders routinely used to take uncapped convertible notes, build value, stretch out the process, and leave the investors getting ever-diminishing rewards all the while that their money was being used to build that value. Investors wised up and began insisting on caps to avoid such abuses. They wanted to protect the idea that they would get significant extra rewards for taking the earliest-stage risk. It was not enough, e.g., to get a 20% price discount at Series A if you convert at $20M pre-money valuation when the company was probably worth no more than, e.g., $5M at the time you invested the seed money. The investor insisted on locking in that ceiling on valuation as a means of self-protection. Does this result in occasional windfalls to bridge investors who take capped notes (or SAFEs)? Yes, it does. Does this arrangement have attributes of something that resembles a liquidation preference in its functioning? Well, yes, it does. Ditto for the full-ratchet anti-dilution attributes. These things are very real attributes that do affect the value of using these tools for founders and their companies. They add to the negative side of the ledger.

But let us say that your startup had to give four times the value in Series A preferred stock relative to other investors to the hypothetical investor noted above ($20M valuation, $5M cap). What does this mean? If that early investor put in $300K and the Series A round was for $7.5M, the early investor might have gotten a windfall but the impact on the round is small because the dollars involved are not large. And if the venture did not do well and the Series A round priced at $3M, then that same investor would still get something like a 20% discount off the lower valuation instead of having had to peg his fortunes to the $5M value used for the cap as he would have had to do had he taken equity. But so what? The dollars are still small and it doesn't matter relative to the value and utility offered by using the convertible note (or SAFE) tool. And, for every "windfall" gained by such investors, you have all sorts of cases where the failure rate is particularly high because of the extreme risks existing at the earliest stages before it is even determined that a company is truly "fundable."

The value of notes and SAFEs is flexibility. Your occasional investor will get special advantages but these are not unduly costly to you as a company. And you have a good measure of control over how you do things. Your first note can be capped but, as you gain traction, later notes can be uncapped. You can raise money at any time without having to worry about creating tax risks and without having to mess up your equity pricing. You can do the number of notes and in the amounts you immediately need. You don't have to go through endless negotiations over the sorts of things that can accompany an equity round (especially protective provisions and similar restrictions on what a company can do). You avoid giving your new investors a veto right or other significant say on what you can do in future rounds, as you would normally have to do if you did an early-stage equity round using preferred stock.

Basically, there is a whole different dynamic in using notes/SAFEs versus doing an equity round. And, in most cases, it is a useful and valuable dynamic for founders and their companies notwithstanding the trade-offs. In this sense, the main idea of this piece that I would strongly disagree with is its suggestion that using convertible notes is somehow a sucker deal. It can be if done wrong but it most often is just the opposite.

Another metric for measuring the relative value of these tools is to see who is using them. Convertible notes have had massive and widely dispersed use now for many years. The most sophisticated investors have had no problem with them in general, and that includes the VCs who lead Series A rounds in which converting noteholders get the benefits of their caps and take more relative value in the round than the VCs themselves do.

As with anything else in the startup world, founders need to use good judgment. The points made in this piece are informed and technically accurate. And they do underscore some clear disadvantages in using notes/SAFEs. My point is that, notwithstanding these defects, notes/SAFEs retain great utility for founders in the context of the broader issues they need to address (minimizing tax risks, keeping stock price low, keeping transaction costs down, etc.). And so this is a good piece to add to your knowledge base but it should not deter you from using non-equity forms of seed funding as long as use of these tools meets your bigger goals. You have control at that stage. Use that control wisely.