Note: This article is the seventh in an ongoing series for Angel Investors. To learn more about developing the key skills needed to make great investments, download this free eBook today Angel 201: The 4 Critical Skills Every Angel Should Master or purchase our books at Amazon.com.
One of the most controversial topics in the startup community relates to the issue of investing through convertible notes vs. investing through preferred stock. Much has been written about this topic for the past decade, and the debate continues to rage in the blogosphere even today.
Even though this topic has been covered by others, we felt it was important to give our perspective. We’ve done hundreds of investments, many using Convertible Notes. So our viewpoint is a practical viewpoint and not an academic one. We live this issue every day and do our best to steer through the minefield and avoid as many mines as possible.
Q: Christopher, tell us a bit about the history of convertible notes. How did they get started in the first place?
In the start-up financing world convertible notes first came into regular use in the context of quick bridge rounds by VCs who had already given a term sheet to a company but would not be able to close quickly enough to meet the company’s immediate cash needs. Convertible notes were a quick and simple way to funnel a little interim working capital into a company while an investing syndicate for a priced round was being built, papered and funded. Once you closed the round in a month or so, you would convert your note right into your own termsheet. Notably, in this scenario there isn’t much pricing risk to allocate between the buyer and seller since the price of the coming round has already been set by the termsheet. Convertible notes made sense in this context, but unfortunately they escaped and metastasized into a general purpose financing tool and are currently used in places where they don’t make as much sense.
Q: So let’s start with situations where you think convertible notes make the most sense. Why would you recommend a convertible note? What are their advantages?
Convertible notes have some advantages, but also some disadvantages. When you net it out, there are only a couple specific situations where the advantages outweigh the disadvantages: (a) very small initial seed rounds and (b) supplemental bridges between priced rounds.
Here’s why: the main things convertible notes have going for them are: (i) they are cheaper to put together because there are fewer legal documents and they are simpler (ii) they are less complex and have fewer variables to negotiate, particularly deal price which is a perennially thorny topic that entrepreneurs like to postpone settling if they can, and (iii) they are not an issuance of stock, so they don’t require a single big coordinated legal closing to re-capitalize the company and revise the charter the way a stock deal does. This means that super early-stage entrepreneurs can try to close individual investors one at a time on a rolling basis, and it means that they can do much smaller rounds without the transaction cost getting too high as a percentage of the round.
Some secondary benefits for entrepreneurs include the fact that no price means the company can keep stock option prices low, and they typically do not require a lead investor, the granting of board seats or agreeing to control provisions. Taken all together, these advantages are fine and dandy for the entrepreneur.
Unfortunately, none of them are advantages for investors - all of the things being scuttled in the name of speed, simplicity and cheapness are important investor protections, or at least more granular ways of allocating risk and reward.
Q: Okay, now let’s discuss the cons. What makes notes so reviled by angel investors? And why wouldn’t an entrepreneur want to use a note?
Issue number one is the very fundamental problem of misalignment between the investor and the entrepreneur on price. In a note, the price of the stock you will get is not set at the time you commit - it will be set at a future time in connection with a future priced round. So if the price on that future round is set high, the entrepreneur wins and gives less stock to the note holders. If the price is set low, the investors win and get more stock for their original investment. Your investors win if you lose. Not a great set of incentives for your investors.
There are a number of ways to address the issue by putting a cap or maximum price at which note holders will convert, and/or promising them an automatic discount on the price of the round, or even giving them some warrants instead of a discount. These mechanisms don’t really solve the problem, and introduce their own set of issues. The cap has the effect of pricing the round (or at least sending a strong price signal) in the eyes of the market, so if the entrepreneur sets the cap high, they are fencing themselves into a high implied valuation that they may not be ready for when the day comes. And if they set it low, they are going to experience a lot of dilution if the round prices a lot higher than the cap and suffer a mounting “note overhang.” They don’t like that, and future investors don’t like that, which creates an incentive to renegotiate the terms of the note, which naturally leads to chaos and animosity all around.
All this is happening at a time when the company is really risky and its theoretical value/valuation is changing extremely rapidly with each step along the progress path. A lot of investors feel that equity upside is the perfect compensation for taking all that early risk on. By investing early they are helping the company get up the really steep part of the valuation curve, and so they ought to benefit from the chance to share with the entrepreneur in that upside they helped create. If you give up that upside by doing a note, the investors are basically taking equity risk for debt returns.
A second problem is that note holders are also assuming the risk that their contractual note terms can be renegotiated at any time (as contrasted with the harder-to-alter rights you get as a holder of equity). It is common that the lead of an equity round will balk at paying, say, for example, a 25% discount for someone who has just lent money to the company a month or two prior to the priced round.
A third problem centers around trying to reconcile a bunch of notes at once. Different batches of notes with different caps can pile up and it can be a mess to figure out how to reconcile them and actually figure out the exact price of the different notes while trying to give effect to multiple notes at once. This pits note-holders against note-holders. Enter later investors, who know that note terms can be changed through re-negotiation, so they can just condition their investment on giving the note holders a haircut and cleaning everything up. Since this type of haircut doesn’t hit the founders in the wallet the way, say, imposing a recap on all early equity holders would, the founders are not economically incentivized to fight the suggestion, putting them once again at odds with their early investors.
A fourth problem is that note holders also have none of the other protections like board seats, protective provisions, a minimum needed for the round to close, pro-rata rights, drag along rights, registration rights, and other key investor rights typically used as part of the economic “package” which makes investing in early stage companies feasible. It is true that you can come up with mechanisms such as note-holders’ agreements, investor rights agreements, voting agreements, side letters, etc. to put any of those features back in, but by the time you have done a capped note with a discount and a bunch of these other bells and whistles, you have destroyed the primary virtue of notes - their cheap simplicity - and yet you still have an awkward transaction compared to a proper priced round.
Related to this issue is the fact that note holders will not have a say in negotiating those features when they do get them. If you price your own round, you can structure all these features as you see fit. But if you buy a note, you are just passively waiting for a subsequent priced round to be negotiated by some 3rdparty, and you may or may not like the terms they negotiate. Whether you like them or not, you are stuck with them, because typically your note automatically converts into the next qualifying priced round.
And finally, with a convertible notes, your holding period does not start the clock for the five year holding period for exemption of gains made on Qualified Small Business Stock under IRS Section 1202. Until you convert to equity, your five year 1202 clock does not start running, which means in an early exit scenario the incredibly powerful benefits of 1202 gains exclusion will not apply to you. (You can use the note holding period to avail of the long-term capital gains rate, but you cannot use it to satisfy the exclusion under 1202.)
For entrepreneurs, one often-overlooked issue with convertible notes is the fact that the notes are legally a debt instrument. This means that, if there is no qualified financing or automatic conversion provision, at the maturity date investors have the legal right to demand repayment with interest which could force the company into bankruptcy (and possibly the founders if they have offered personal guarantees on the debt). That can be one heck of a mess if the maturity date creeps up on an entrepreneur at an awkward time when it just happens that the company is not really thriving.
So at the end of the day, convertible notes (and other deferred pricing structures like SAFEs) are not good for investors and they are also not ideal for entrepreneurs. Their defects tend to get over-looked in very small rounds because they are a cheap and easy transaction to do, and they can be a quick and expedient way to bridge in some cash while avoiding re-pricing a later stage company between priced rounds. But outside of those two scenarios, they just don’t serve their intended function well. If you just want a cheap transaction with few protections, I’d suggest it would be better to just buy some common stock - you would certainly have better alignment with your founders that way.
Q: I expect the debate around the merits of Convertible Notes will continue to rage for years to come. Any last parting thoughts you would like to lay out on the table?
Yes. Believe it or not I have just skimmed the surface of this issue and talked about the basic issues. There are actually quite a few more subtle legal and economic issues involved with notes, each of which have the potential to be equally important, especially for entrepreneurs. For people seeking more detail, I recommend some great writing by VC Mark Suster on this topic as well as some of the other pieces he links to.
Net/net, notes are just not a good way to do primary investment rounds in startups. It is really a shame that they have become a market standard and the only way a lot of rounds can get done. For more on debt vs. equity and all of the variations, check out Overview of Early Stage Deal Structures.
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