Every so often, I get asked a variant of this question: Should I use a convertible note to finance my start-up? Just what is a convertible note and who uses it?
Generally speaking, convertible notes are used when start-ups and their prospective investors want to get a financing done quickly and not waste time trying to value a company that may be too early to value correctly. The standard and in some ways preferred way to fund companies is with equity capital, but convertible notes offer a nice alternative when you do need them.
One variant of the above question from Quora is:
Where are shareholder rights (tag along, non-dilution, governance) treated in a convertible note financing? In theory, convertible notes are debt instruments that wouldn't allow its holders the same type of shareholder rights as shareholders. Do VCs that opt for a convertible abide [I think the questioner meant waive, not abide] these rights or can these rights be present in a convertible note?
A great answer to this comes from David Rose:
Ah hah! Now you see why VCs rarely do convertible notes.
It's possible to write any terms into any type of instrument, but since the primary purpose of making a small investment under a convertible note is to do it quickly and hold off the messy details (aka, "shareholder protections") until a larger equity round with sophisticated, empowered investors, it would be counterproductive to load up a note with all of those messy details.
By definition, "Shareholder rights" are the rights of "shareholders". And if you're loaning a company money, you are a lender, not a shareholder.
The bottom line is that, despite much blogosphere hoopla to the contrary, an investor needs to make a decision up front as to whether to do a "quick and dirty" round with a limited amount of money, few if any protections and terms to be set later by someone else...or whether to bite the bullet and get the messy details agreed upon from the beginning.
(That said, although the typical convertible note is usually only a couple of pages, I have seen (and used) ones that spell everything out, including all of the protections and governance issues that would be a normal part of an equity round. But if you're then going to end up with a fifteen page note that looks like an equity round, why not just do the equity round?)
Convertible notes can be used appropriately or they can be unnecessarily abused. Some investors I know of have "standard" documentation that goes way beyond David's full-fledged 15-page example above, instead going on for anywhere from 70 to 100 pages and beyond. If you are a start-up, especially the sort of very early-stage start-up that may consider issuing a note instead of equity, then this is the sort of legal hell overhead you certainly do not need and cannot afford.