September 2013

by Keith White

Convertible notes are all the rage in early-stage financings.  Here is our guide to convertible notes with what we’ve garnered from our experience with them.  In short, they are neither the panacea their proponents promote them as nor the blight their critics complain of.  They are a potentially useful tool that must be understood to be used properly.
Note: These points are listed roughly from beginner to advanced, so experts might want to read bottom-to-top. 

  • A convertible note combines features of a loan or debt, typically interest and priority in a default, with the ability to convert into equity, giving greater financial upside to the investor if the firm flourishes. 
  • Startups typically defer the interest rather than pay it in cash, meaning it gets added to the value the noteholders will convert.
  • Notes often include “discounts,” the ability to convert to equity at a lower price than subsequent investors in the next round.  We sometimes hear subsequent investors grumbling about this but we think that’s unreasonable since the noteholders invested earlier and earlier investors deserve more upside.
  • In big corporations, the conversion feature is usually considered a fallback option, but with startups conversion is expected because it’s hoped the company value will increase dramatically.
  • If you issue equity, you generally give all investors the same terms for legal and expectational reasons.  Notes can give the flexibility of offering different terms to different investors.  However, the same feat can be accomplished with equity through warrants.  We can show you how.

Valuation Caps
  •  Startups often offer convertible notes with valuation “caps,” which allow a note investor to gain value for company growth between the purchase of the note and its conversion in the next round.  If the note has no cap, the investor would only benefit from growth AFTER conversion.
  • People often hear “cap” and think the return is capped, but in fact it’s the dilution that’s capped.  This means a cap favors the investor, not the founders. 
  • An example:  If an investor invests in a convertible note with a $4M cap and the firm is subsequently valued at $8M, the investor has doubled their money.
  • Don’t confuse the “cap” in a valuation cap with the “cap” in the “cap table.”  In the former, cap means limit.  In the latter it is short for “capitalization.”
  • Convertible notes with caps can give investors high, equity-like upside with low, debt-like downside.
Potential Misconceptions
  •  Many notes are described as having a valuation cap AND a discount.  This is grammatically imprecise.  When converting to equity, most deals apply a cap OR a discount, whichever is better for the INVESTOR.  We can show you how to calculate which applies.  Generally, the higher the valuation at conversion, the stronger the case for applying the cap.  It’s analogous to the “make-or-buy” problem you may have seen in business or economics class.
  • Some say convertible notes are faster & easier to negotiate than priced equity offerings.  We consider this “sort of true.”
      The initial paperwork can be easier since noteholders usually don’t get ownership rights like board seats and voting rights, which are complicated terms to negotiate.
      Notes avoid having to set a valuation on the company, essentially “punting” that until the next round.
    But…
      Reasonable professionals can often negotiate valuation & terms quickly in an equity offering, mitigating notes’ advantage.
      Notes have other terms to negotiate like interest, caps, discounts, maturity dates and conversion terms.
      A valuation cap acts like an implied valuation if triggered, so if a cap is offered you still have to think about valuation.
      Tracking the accumulation of interest can mean more paperwork later, especially if you offer different investors different terms.
    Still…
    ·   Issuing notes means you don’t have to create a valuation for tax purposes, which is required in an equity offering.
    Important But Often Overlooked Elements
    • In a down-round, the face value of notes doesn’t decline with the value of the company, so they act like “full ratchet anti-dilution” clauses.  If there’s a discount, it may still apply and notes are even more dilutive.  Expensive capital in these cases.
    • Notes typically have maturity dates.  If a firm can’t raise another round before maturity to force conversion, they technically have to pay back the loan (and interest) with cash, often causing a default.  In reality the company tries to renegotiate, but that’s no fun and success is uncertain. This maturity problem is exacerbated by the development of the Series A crunch, where many firms get seed funding but can’t get Series A funding because VCs are now preferring bigger deals (Series B+).
    • If a note converts into a class of equity with a liquidation preference, the noteholder gets that preference too.  For example, investing $500K in a note with a $4M cap and converting into equity with a 1x participating preference at an $8M valuation means a noteholder quadruples their money in a liquidation (doubling once due the the cap and doubling again due to the preference).
    •  Note terms are often expressed as price-per-share in calculations & contracts.  If you find that confusing, try calculating percentage ownership and investment value first.  Many clients find that more intuitive.  We can show you how.

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