A note on convertible notes
As with many trends related to entertainment or technology, the market for early-stage capital often experiences a ripple effect carrying prevalent practices from the West Coast eastward. One of those waves that has recently swelled to significant heights in our local market is the prevalence of startups raising their first round of outside capital in the form of convertible notes.
While there are certainly appropriate times and situations for using convertible notes, we at UCAN and the SC Angel Network find that startups too often default to convertible notes when they are not the best approach – for the entrepreneurs or the investors.
By definition, convertible notes, which are a form of debt, are intended to convert into equity – or a portion of ownership in the company – in the future. By structuring the investment as debt rather than equity, the entrepreneurs and investors delay the always-challenging task of determining a price, or valuation, for the company. Instead, the note is structured to convert into equity based on the price of an assumed future round of equity investment, usually at a discount of 10 to 25 percent of the price of the new round.
While the discount provides some additional value for the early investors, it rarely provides adequate compensation for the disproportionate risk the note holders took prior to the new round of investment. If the company successfully deploys the capital from the convertible note and gains traction according to its plan, the price of the new round of equity will be such that even with the discount, noteholders pay a much higher price than would have been appropriate for the level of risk at the time of investment.
A valuation cap can be added to the terms of the note to mitigate this risk for investors, but in most cases the cap is still higher than the appropriate valuation at the time – and since the cap requires a price negotiation anyway (which notes are designed to avoid), it usually makes more sense to negotiate a fair price for the equity at the time of the original investment.
No pathway to conversion
A more acute risk in our market – unlike the West Coast where venture capital is relatively abundant – is that the so-called “bridge note” turns into a “pier” with no clear pathway to conversion, which leaves investors and entrepreneurs in a precarious position.
For instance, 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 accruing interest can add up to a large number that may severely limit the company’s future prospects.
Any new equity investor will adjust down the pre-money valuation offered in order to account for the post-investment impact of the converting principal and interest from the notes. Additionally, if the bridge becomes a pier, the accruing debt can ultimately put investors in position to call their notes, pushing the company into default and ultimately taking over the assets of the company with no recourse for the equity holders like founders and employees.
Tax consequences and misalignment
Another key issue for investors is the tax consequences of convertible notes. When the accruing interest on the note converts into equity at the time of conversion, investors are required to pay income tax on the interest earned – even though they are not receiving cash from the company. 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 – so if the company were to be acquired within the first year after conversion, investors would be required to pay ordinary income taxes on their gains, rather than the capital gains rate which would apply in the case of an equity investment held for more than one year.
Perhaps the most problematic aspect of using convertible notes is the misalignment it creates between investors and entrepreneurs. When it comes time for the next round of investment, instead of investors and founders being aligned as equity holders seeking the highest reasonable valuation, the investors now have incentive to argue for a lower valuation to improve their equity position upon conversion.
Furthermore, by delaying the conversation about valuation, the entrepreneurs miss an opportunity to test the relationship with the investor, and vice versa. If the two parties can’t have a productive conversation about the subjective and challenging topic of valuation, it may signal potential issues the parties will encounter when faced with the inevitable, inherent challenges and conflicts that arise in all startup companies.
Finally, many entrepreneurs choose to raise money via convertible notes because they can 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. 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.
Given the challenges associated with convertible notes, we at UCAN and SCAN tend to avoid them (except in cases where there is a high probability of a conversion event or acquisition within just a few months of the note investment), and we encourage entrepreneurs to think twice before defaulting to the trendy wave of convertible notes.