The Case Against Convertible Notes
At VentureSouth, we often find ourselves fielding pitches from entrepreneurs attempting to raise capital via convertible notes. And almost as frequently, we find ourselves pushing back against the convertible note structure in favor of a priced equity round.
Since many founders now seem to default to convertible notes for their first round of funding, we want to lay out our rationale for why we think that structure is usually not the best approach — for entrepreneurs or investors.
For new founders or investors who may be unfamiliar with the details of convertible notes, you can start here with our quick primer on the important terms you need to know. Then come back here for the reasons we typically steer clear of convertible notes.
First we will cover the primary downside rationale for founders; we then outlines our key objections from the point of view of investors; and lastly we uncover some of the hidden costs of convertible notes that are rarely acknowledged.
Convertible Note Downsides for Founders
Perhaps the most problematic aspect of using convertible notes is the misalignment it creates between entrepreneurs and their investors. Whereas equity investors are on the same side of the table as founders when it comes time to raise the next round of funding (and will help advocate for the highest reasonable valuation), noteholders are actually on the other side of that equation in that they benefit more from a lower valuation (since their debt will convert to equity based on the price of the next round — and the lower the price, the more equity they will own upon conversion). While entrepreneurs might like to think that investors would be just as supportive in either case, incentives matter and the misalignment of interests can create problematic friction at just the wrong time when trying to raise the next round.
Of course the primary reason most founders pursue convertible notes is to avoid the presumably difficult exercise of agreeing to a valuation for the company. While it is true that early-stage valuations are more art than science, there are plenty of well-established methods and rules of thumb for establishing an appropriate valuation. Unfortunately, since the ultimate ownership stake for the convertible note round is unknown at the time of investment, entrepreneurs are often unpleasantly surprised when they finally see the full impact of the dilution from the accrued interest and conversion discount associated with the notes.
Additionally, an unwillingness to engage in valuation discussions and debate may signal to an investor that the entrepreneur hasn’t done his or her homework on what to expect when fundraising, which can undermine the credibility needed to secure an investment. Lastly, the valuation exercise provides founders with an opportunity to work through a potentially challenging discussion with the investor — which can provide invaluable insight into how well the two parties may be able to work together (or not) in navigating the inevitable future challenges all startups face.
Entrepreneurs often fail to recognize the crippling impact an unconverted note can have on the company’s balance sheet. If the note doesn’t convert in a relatively short time frame, the continuously growing liability (from the accruing interest) can add up to a significant number that makes the balance sheet a significant barrier to future fundraising efforts. And of course new equity investors will anticipate the dilutive impact of the converting notes by adjusting their valuation offer downward accordingly.
While the convertible notes continue to accrue interest, the future dilution to founders is accelerating as well. Remember that the principal and interest of the note will convert into the next round — at a discounted price — so the longer the note remains outstanding, the more shares investors will receive at conversion — and the further founders will be diluted. In our simple example, you can see that a $1,000,000 initial convertible note in this case turns into $1,375,000 worth of shares at conversion (because of the accrued interest and conversion discount).
Piers vs bridges
While a convertible note is intended to provide sufficient runway to reach a future funding event, too often the would-be “bridge” becomes a pier, leaving the company stranded between the accruing liability from the notes and their efforts to reach the “other side” with a new, fairly-priced equity round. If no conversion event appears on the horizon, the investors may decide to call their notes at maturity, pushing the company into default and ultimately taking over the assets with no recourse for equity holders like founders and employees.
Many entrepreneurs choose to raise money via convertible notes because they can often be issued faster and cheaper than a preferred equity round. While this is true to some extent, the advent of standardized equity round documents like Series Seed has mitigated these differences significantly. An experienced, reputable law firm that works with startups should be able to execute the equity documents at a reasonable price that is not significantly higher than the cost of convertible note documents. In the end, creating alignment between investors and founders will prove to be much less expensive than the incremental cost of issuing equity instead of a convertible note.
Convertible Note Downsides for Investors
While the discount on a convertible note provides some additional value for the early investors, it rarely provides adequate compensation for the disproportionate risk the noteholders took at the time of their investment. The standard discount on a convertible note is usually around 20%, but in most cases the actual value of the company at the time of the note investment is likely 40%-50% lower than the valuation at the time of the next equity round — so the investors are almost always overpaying. A valuation cap can (and should) be added to the note to mitigate this risk for investors, but in most cases the cap is still higher than the appropriate valuation at the time of investment. And since establishing a valuation cap requires a price negotiation anyway (which convertible notes are designed to avoid), it usually makes more sense to go ahead and do the hard work of negotiating a fair price for the equity at the time of the original investment, rather than punting that determination to some unknown point in the future.
Investors should avoid investing in convertible notes without valuation caps. If the entrepreneurs are successful in deploying investor capital to build significant momentum, the price of the next round is likely to be much higher than the investors anticipated, leading to a much higher conversion price (and lower equity stake) than they reasonably expected. Essentially, the company has taken investors money at the highest risk stage of the business and used that capital to drive up the price the investors pay to own a piece of the business they helped accelerate!
Tax on interest
Another key issue for investors are the tax consequences of convertible notes. When the accruing interest on a convertible note converts into equity, investors are required to pay income tax on the interest earned — even though they are not receiving cash from the company.
Capital gains and QSBS treatment
Additionally, the capital gains clock for investors doesn’t start at the time of the convertible note investment, but rather at the time of conversion. This creates a scenario in which a company could take advantage of an early exit opportunity, say 18 months after raising a convertible note, but if the noteholders converted 9 months after the initial investment, they would be subject to ordinary income tax rather than the lower capital gains rate which would apply for an equity investment held for more than one year. Perhaps even more importantly, the five year clock for 100% capital gains exclusion under the Section 1202 Qualified Small Business Stock provisions only starts at conversion, not at the time of the original convertible note investment.
Testing the relationship
Above, in the section on avoiding valuation discussions, convertible notes circumvent an opportunity for investors and entrepreneurs to test the relationship. If the two parties can’t have a productive, respectful conversation about the subjective and challenging topic of valuation, it may signal potential strain in the working relationship when faced with the inevitable, inherent challenges and conflicts that arise in all startup companies.
As a quick aside, we do want to acknowledge that there are a limited number of situations where we think convertible notes are appropriate.
Namely, we support convertible notes only when they provide a true “bridge” to a near-term conversion or acquisition event. These notes should represent a relatively limited amount of capital (typically less than $500K) that is intended to carry the company to the conversion or acquisition event within three to six months.
Hidden Costs of Convertible Notes
To wrap things up, let’s consider some of the hidden costs of convertible notes that are rarely discovered until the conversion event is imminent.
Let’s suppose a founder raises a Seed round at $1.00 per share, then later raises a “bridge note” with a 20% conversion discount. Then let’s suppose the company raises a Series A round at $1.10 per share, so the conversion price on the note will be $0.88 ($1.10 x 80%). Of course, this conversion price is below the price of the Seed round, so assuming that the Seed round carried a weighted-average anti-dilution provision (like most of them do), the Series A round has now triggered the anti-dilution clause for the Seed round. That essentially means those Seed round investors will get credit for more shares than they bought when it is time to exit, further diluting the founders. For more detail on how the math works for anti-dilution triggers (and other scenarios), check out our workshop on Understanding Cap Tables.
Once a company starts dealing with the complexities and conditions associated with converting notes and handling potential anti-dilution clauses, it begins to rack up more time on the clock with legal counsel who now has to work out the math and confirm all the complicated details. This of course starts to add up in billable time — and we have seen more than one case where the lawyers actually got the math wrong — which is an even bigger risk. So in general, founders are better off avoiding complexity, uncertainty and confusion around who owns what — which will save time and money and stress when it comes to the legal work involved in the next funding round.
Remember that convertible notes typically involve a minimum threshold for raising the next round, so if founders set that bar moderately high and things don’t take off like the rocket ship they envisioned, the company may have a hard time raising enough money to meet the minimum threshold. In that case, noteholders might decide to hold out rather than waiving the minimum to convert (remember the misalignment we discussed above), and since the new equity investors are highly unlikely to invest if there would still be unconverted notes outstanding after the round closes — the entire round could be sabotaged.
We’ve seen a disturbing trend in which founders will not only raise an initial convertible note — but then they will stack additional notes on top of the first one before raising an equity round. We’ve seen up to four (!) consecutive stacked notes with different terms — which makes it very difficult to get a new equity round structured given the aforementioned complications and the substantial additional dilution that must be taken into account from the interest and discounts on the multiple notes. Depending on the terms, this cascade of circularities and complexities will drastically lower the chances of securing a new equity round — or significantly increase the time, cost and stress of completing one.
A note on SAFEs
Of course, others have recognized many of these challenges stemming from convertible notes. In response, several years ago, Y-combinator introduced a novel new structure designed to circumvent some of the key issues stemming from the interest provisions of convertible notes. The Simple Agreement for Future Equity (SAFE) is essentially a convertible note without the interest, which eliminates some of the problems highlighted in our series. While the SAFE structure is a partially helpful step in the right direction, it still does not address the more fundamental problems with convertible notes (namely, a lack of clarity and agreement on valuation and ownership, which leads to misalignment, uncertainty and potential future cost, complexity and contentiousness). So, not surprisingly, we view SAFEs in the same bucket as convertible notes — a problematic structure only appropriate for very limited situations.
We certainly haven’t covered every wrinkle or nuance about convertible notes in this article, but we hope we’ve provided some insight on the hidden and not-so-hidden disadvantages they carry.
We welcome your comments, feedback, suggestions and corrections on this Case Against Convertible Notes. Thanks for reading and best of luck in your fundraising and/or investing!