More and more entrepreneurs are turning to convertible notes when raising an investment round. Put simply, a convertible note is a type of debt which converts into equity when triggered by a subsequent fundraise. Although this seems a straightforward definition, much discourse and debate surrounds convertible notes. Given the increased use of this security type in early-stage financings, it is important for both entrepreneurs and investors to form a more complete understanding of these instruments.
Simple Structure, Fewer Complications
The main benefit of a convertible note is their relatively simple structure. Startup financing rounds can quickly become complex and take up significant time and money. Convertible note financings tend to be faster, simpler, and cheaper than priced rounds. In a priced round, actual ownership stakes in the company are sold. By contrast, convertible notes are technically a form of debt, meaning there is no need to create a second class of shares or issue common stock. This avoids a number of complications, including those arising from company valuations, stock option grants, and related tax implications. At the end of the day, this allows entrepreneurs to focus more of their time and energy on their company and on generating potential returns for their investors.
Advantages of a Pre-Valuation Investment
One of the most important – and therefore contentious – variables associated with any priced round is the pre-money valuation (the value of the company at the time of the investment). The valuation determines what percent of the company is being offered. This value, however, can be difficult to determine for many early-stage ventures. Convertible notes allow issuers to defer valuation negotiations until a subsequent round of financing. This affords the company time to develop metrics which can be used to determine a fair price in subsequent rounds of funding.
The structure of a convertible note is designed to benefit those investors willing to take the risk of investing before these metrics are developed. The convertible note discount rate allows investors to convert the amount of their loan, plus accrued interest, into equity at a reduced price relative to the investors in that subsequent round. Similarly, the note’s valuation cap establishes a maximum value of the company at that future financing, which also potentially allows noteholders to convert their investment into equity at a more favorable price per share.
One of the largest rounds that I’ve worked on recently has been the Patch of Land funding round which used a convertible note. During our due diligence process Jason Fritton told me “We chose to raise using a convertible note because it will allow us to prove out some of our key metrics before we raise a priced round in the near future.”
Some Investors Averse to Convertible Notes
Although there are benefits to their use, convertible notes do have drawbacks that both investors and entrepreneurs should keep in mind. It can be difficult for new investors to establish whether the terms of a particular note offering are fair, driving some away from deals financed with convertible notes. Some investors prefer to wait until a priced round, even while acknowledging they will most likely pay a higher price.
These investors are typically wary of foregoing the rights associated with being a shareholder such as: voting rights, control rights, pro-rata rights, and liquidation preferences. Furthermore, convertible noteholders usually cannot take advantage of the long-term capital gains treatment available to stockholders until the time of the note’s conversion.
Lack of Noteholder Control
Convertible noteholders are often at the mercy of others, with little power to sway the outcome of their investments (at least until the conversion event). More often than not, the valuation of a noteholder’s investment will be determined by future investors who may negotiate a valuation with which the noteholder does not agree. Furthermore, if convertible notes are uncapped, the interests of the issuer and the noteholders are not aligned when it comes to this valuation, as issuers want the valuation to be as high as possible, while noteholders want the opposite.
Beneficial Now, But For How Long?
Due to the current complications surrounding priced rounds, convertible notes can streamline a startup’s fundraising process. As standardization increases the speed, reduces the cost, and minimizes complexity of priced rounds, the benefits associated with convertible notes will become more muted. In the meantime, convertible notes can still serve as a mutually agreeable form of financing, quickly delivering much needed capital to startups and potentially large returns to investors.
– Aaron Kellner is an Investment Director at SeedInvest. Prior to joining SeedInvest, Aaron co-founded a mobile games development company. He has also worked at Goldman Sachs and a small-cap investment fund.
This post was written by aaronkellner on September 1, 2016
Pros and Cons of Convertible Notes