Why We Really Dislike Convertible Notes
We see Convertible Note deals all the time. Generally, we really dislike them as bad for both the entrepreneur and the investor, for all kinds of reasons...
If you scroll to the bottom of this longish article you'll find almost two dozen articles explaining how Convertible Notes work and why they're problematic - for both sides of the table.
There are many, many more articles to be found, but we've curated these as each brings at least one new idea to the table. We've tried to summarize all those ideas in this article.
Some arguments are fairly complex, the stuff of veteran entrepreneurs and investors that have been burned, or at least unpleasantly surprised, in the past.
The fundamental argument though, is simple: as Stu Strumwasser writes in Nosh:
Mr. Strumwasser's investor-centric view is correctly re-iterated by every other article author. But it omits, in his own example, the harm to the founders that we'll see below.
Convertible Note Overview
A "convertible note" is one of many investment vehicles - contracts between an investor and an company - used to get money into a company to help it grow then, eventually, get that money back out to the investor, with some return. Convertibles are usually used at the "Seed" stage of financing, that is, after maybe a little friends and family common stock money at the Concept stage but before the "Series A" stage equity round.
They're called "convertible" because they start out as debt (a "note"), then given certain circumstances "convert" into equity. Usually that equity is "preferred stock." The conversion circumstances typically include either the company raising another round of funding, or selling, or the passage of some amount of time, usually around 18 months.
Prior to conversion, convertibles are a debt that, like all debt, is senior to all equity holders. Convertible debt is usually on equal footing (called "pari passu") with other non-secured junior debt. A bank loan backed by a specific piece of collateral would be an example of "secured, senior debt", which has to get paid before holders of a convertible get paid.
Key Features of a Convertible Note
The key features of a convertible are:
Supposed Reasons Convertibles are Good
Convertible notes are very popular and often recommended by incubators, accelerators, tech-focused angel networks, and for some odd reason, a good number of lawyers.
The table below summarizes the reasons folks like convertibles, and why we think those reasons are bunk.
Bad and Bad
Here's a summary of why we think Convertible Notes are bad for Founders, and bad for Investors.
Valuation and Risk Premium
Mark Suster writes in TechCrunch: "What the entrepreneurs were really saying is, “I don’t want to take a lower valuation now, while I don’t have customers or a full team. I want to use investor money to build these things. Then those investors – the ones who took the most risks (i.e. my friends, family & former colleagues) – get to pay a higher price later when a VC comes in and prices the round.”
Many authors note that un-capped rounds are virtually unheard of these days, because the better the company does (ie, the higher its next round valuation is), the worse early investors do, as described above.
So, we get capped rounds. Suster again: "Make no mistake — [a cap] IS a priced round. In fact, in some ways can be worse for the entrepreneur. It basically sets your maximum price rather than your actual price. Example: If you do a convertible note raising $400k at a $3.6m pre money you’re ceiling is that you’ve given away 10% of the company ($400k/$4m post money). But your actual next round might come in at $2m pre money. You might have been better just negotiating an agreed price in the first place. Not always, but sometimes."
VALUATION = CAP - DISCOUNT
So why the hesitancy to set a valuation, to price the round? The real answer is that if it were to be done, the price would be very low. Concept and SEED stage companies typically don't have real business traction: real customers, a real business model, real traction. Their "valuation" is completely speculative, with innumerable risk factors. Realistically, they're just not worth much. Rather than accept that awful truth (and the significant founder dilution that would come with it), founders and convertible note investors jointly enter into a mutual delusion, with the idea that they can "kick the can down the road" to let someone else figure out the price.
Writes Fred Wilson: "Obtaining a fair valuation may be tricky for unsophisticated investors, but not for sophisticated ones. I can negotiate a fair price with an entrepreneur in five minutes…”
He continues: "Fans of convertible debt argue that debt with a valuation cap is no different than a priced equity round. That is true if the valuation cap is the same as the valuation that the investors would pay if it was equity. But if that is the case, then the entrepreneur is getting screwed. He or she is agreeing to either take the valuation that would have been offered, or something lower if the next round is lower. That is not a good deal for the entrepreneur."
In the rush of adrenaline that accompanies getting a deal done, combined with the start-up media-driven message that "fundraising = success" (vs the longer term view that a successful, impactful business = success) entrepreneurs can lose sight of math. Yes, math, spreadsheets, calculations.
Without creating a spreadsheet that takes into account accrued interest, discounts, liquidity preferences, conversion provisions, stock options, warrants, and various future valuation scenarios, it is very difficult to understand the power of compound math on eventual founder ownership stakes. We can't emphasize enough how important it is for founders to do those spreadsheets so that they can really grok implications.
Together, we call it all "sneaky dilution".
First, there's the easy stuff:
But let's get a little trickier...
The Full Ratchet
Years ago, there was a standard anti-dilution provision in VC terms sheets that basically said "if some other investor comes in after me at a better price, whatever price I paid gets converted to that lower price." So, if the first round investor paid $10 per share for 10% of the company, then the next round investor paid only $5 per share for an equal 10% of the company, the first round investor would magically get their investment repriced from $10 to $5, meaning they'd automatically now own 20% of the firm rather than their original 10%. This was called the "full ratchet", and it isn't used much anymore because founders just won't stand for it, and if granted to one round of investors all future investors will demand it.
But, it turns out, convertible debt with a cap acts a whole lot like a full ratchet! How?
Because conversion happens at the lower of the next round or the cap: Let's say that in the convertible round the cap = the company's valuation at that moment, as argued above. Let's say it is $6M. A year later, the company goes out for a Series A round, and given a year of history, new market entrants, whatever, the founders and reasonable Series A investors agree that the valuation is now $3M. What happens to those convertible note holders? They convert at the lower of the cap or the next round's valuation. So they convert to equity at $3M. Voila, the Full Ratchet!
But it is actually worse for the founders, because, depending on terms, the convertible note investors may also get the discount, and/or the accrued interest, making their effective conversion rate even lower. You have to do that spreadsheet!
The Effective Liquidation Preference Multiple
Many of the articles linked to below discuss "effective liquidation preference multiples", or the amount of equity investors actually end up with (which is the inverse of the amount of dilution founders actually suffer.) We like Silicon Hills Lawyer's Jose Ancer's example best:
You would think it would be easy to take the legal verbiage from a convertible note agreement and turn it into a spreadsheet that clearly shows what happens in various scenarios when the convertible converts.
Pro Tip: give it a try. If you can create that spreadsheet, and all the founders, attorneys, investors, and CPAs agree the legalese and the Excel sync up, congratulations, you have a defined and understandable deal - and a roadmap for when conversion actually happens.
Here are some of the areas that can cause confusion:
The Hampster Wheel of Fundraising
There are two black cloth sling chairs in the FI office, just under the mounted head of Boris, our mascot, a feral pig shot in the 30's by a relative of one of our founders. In those chairs have sat countless entrepreneurs, recounting their pain and remorse for having willingly climbed into what we call "the hamster wheel of fundraising".
The hamster wheel of fundraising works like this:
Wow. Sorry about that. Pretty depressing. But not as depressing as the true-life stories of the humans sitting on those black sling chairs, Boris's fangs snarling above them, feeling no control, no optionality: "we're on this track now and don't have any other option."
The gateway drug of choice for this sad state: Convertible Notes.
Even Worse: SAFES, KISS, and ...
SAFEs (Simple Agreement for Future Equity) were introduced by Y-Combinator in 2009. It is like a convertible note but it isn't debt, so has no interest or maturity date, or obligation on the company's part to pay it back. It also isn't equity, but rather a contract for the investor to get equity at some point in the future for investment money now. SAFEs are kind of like warrants (which also grant the holder the right to future equity), but in a SAFE investors put money in upfront vs a warrant where the money goes in later, when the warrant is exercised. SAFEs were invented to decrease legal fees and negotiation timeframes. But, they have all the problems of convertible notes, and aren't even debt.
The KISS (Keep It Simple Security) is a invention of 500 Startups, launched in 2014. Keeping it simple, there are two versions of the KISS: a debt version and an equity version. Like SAFEs, KISS function very similarly to a convertible note and thus inherit all the issues. Unlike SAFEs, KISSs do have a interest rate and a maturity, and KISSs have a larger number of terms, including exit premiums, requiring more issuer sophistication.
Here's an overview of the two.
The One Situation Where We Actually Like Convertible Notes
Because there seems to be an asterisk associated with everything, you would know there is one place we like the idea of a convertible note: for very early stage, very small dollar - or in-kind - infusions.
Some investors aren't motivated by financial concerns so much as just wanting to help the founders out. Such investors could just gift the money, but maybe they're concerned about gift tax implications, or want the founder to have some skin in the game, or want a lotto ticket that maybe, someday, they get the money back and maybe even with some return.
In those cases, we can eliminate all the reasons convertibles are bad for investors, because these investors really don't care. And, assuming the convertible used is a super-stripped-down, with no cap, the founder issues could be palatable as well.
Here's how such a thing could work: family and/or friends could pump in $5-$15k, or a advisor or consultant, or even a vendor could keep track of fees or costs and accrue that in-kind contribution. In either case, a simple, stripped-down convertible note could say that the investor money, or the value of the services provided, would convert after some time period into whatever next round vehicle happens, with whatever next round terms are negotiated, on the exact same terms as that next round. Or, if no future round happens, the family round investment or service provided accumulated debt turns into a simple signature loan at some point in time.
Even so, the problems with convertibles exist, but the parties aren't concerned. If things go well, the investment turns into something. If it doesn't, it's a straight note that the holder/lender/investor can decide how vigorously they want to pursue.
If you read this far, congratulations! What a slog, eh?
Net net: If you want to raise equity, do it with either a simple friends and family common stock round or a Series A preferred. If you want to use debt, do it with either a signature loan, or something collateralized, or revenue-based financing. If you want to do something in-between, some sort of hybrid, consider Redeemable Preferred Stock, or a Demand Dividend, or the claim-on-cashflow equity method used by restaurants and sometimes real estate deals.
But please, stay away from Convertible Notes!
We're very much appreciative of the work explaining convertible notes from the following sources:
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