Mark Suster has struck again with yet another contribution to the seemingly endless debate about convertible notes versus priced seed rounds.  His conclusions will, of course, shock and amaze:  Price the “effing” round.  All the investors agree.  (I probably overstated that.)

I don’t want to rehash the now tedious discussion, but the following thought has occurred to me more than once:  Investors who hold notes that are convertible at a discount are indifferent to the next round valuation (sort of – (a) a low valuation theoretically helps the return on the seed investment and (b) everyone likes to invest in a company that made it big).  These investors have a built in return that they will book at the next round no matter what the pricing of that round is. 

At the risk of being boring, a note that converts at a 20% discount to the next round provides a 25% return upon conversion whether the round is priced at $10 million or $500 million. 

So, consider this:  A VC investor who puts $500K into a priced seed round with the expectation of investing $5mm in the A round will want a low valuation on the A round.  It is in the VC’s economic best interest to get a “good deal” on his $5mm investment, to the detriment of the return on his seed investment because the seed investment is nominal by comparison to the A rond investment.  On top of this motive, the VC is probably on your board and probably has blocking rights, rights of first refusal etc.  As a practical matter, bringing in a true competitive bid will be difficult on a good day.  In fact, if there are blocking rights it may be impossible.

Also, consider this:  An angel who puts $500K into a priced seed round without the expectation of participating in the A round (or perhaps hoping to have a minimal participation) will want a really high valuation to avoid dilution.  Note this investor will also be worrying about later rounds.  Again, because of contractual rights (such as the right to block the issuance of senior preferred) this investor may be in a position to affect your ability to raise the next round.  Now, you can usually get around this issue because it always comes down to "raise the new money or die", and the investor will go with the obviously correct choice.  But, make no mistake about it, these investors can and do create major problems from time to time.

Now consider this:  A VC with a $500K principle amount convertible note (at a 20% discount and no cap) will get a 25% return on the $500K at the closing of the A round without regard to valuation.  He will be planning to make his return on his A round investment and will negotiate like a VC to get a “good deal.”  But, these notes are typically done without all the ancillary documentation that accompanies priced seed rounds.  As a result, the holders do not have blocking rights.  Because of signaling and other issues (the investor is already involved with the company, he may have rights of first refusal etc.) the VC investor will be tough to deal with, but, from the entrepreneur’s point of view, it probably beats having to deal with all the contractual rights inherent in a priced seed round.

Finally, consider the angel investor holding the proverbial convertible note:  Economic indifference to the pricing (sort of – see my parenthetical in the second paragraph), fewer contractual rights, and no substantial new investment in the next round – how much better does it get?

As Suster points out, it is hard to argue that investors should like convertible notes (without caps), but it is also hard to argue that entrepreneurs should not like them.  In the end, it seems to me that this is all about supply, demand, familiarly with investments, savvy and negotiation.  Familiarity and savvy are usually on the side of the VC.  Because of the dynamics of the seed market, as it exists today (see Andy Payne’s recent blog regarding the glut of angel money), supply and demand may be on the side of the entrepreneur (for once).  Don’t feel bad about getting a “good deal”; investors sure won’t.