Seven Surprises About Convertible Notes That Founders Should Know

Opinion

Over the past two years, there has been an explosion of the use of convertible notes for seed rounds. It used to be these debt instruments that convert to equity later at a discount to the price of the next round were only for small initial financings of, say, $250,000 for a company to get going. Now, we have been seeing note rounds of over $1 million fairly frequently.

Founders usually view these as being company-friendly: less dilution, faster, and cheaper than equity rounds. None of these is necessarily true. Some commentators, including Mark Suster, have come out fairly strongly against notes. It comes as an unpleasant surprise that sometimes there are issues.

“Calling it ‘issues’ is an understatement,” says Anna Palmer, CEO and co-founder of Fashion Project. “I have now been cautioning other entrepreneurs on the dangers of capped convertible notes and trying to make sure they really understand what they mean. Had I known what I know now I would have only used them for our first exploratory round and nothing beyond that.”

“There certainly is a place for notes early on in your growth—the initial $250-500K or so—where it can get funky is the larger, $2M and more initial rounds,” says Jeff Bussgang, general partner at Flybridge Capital.

What happened at Fashion Project is unfortunate but not that unusual. In their case, there were many notes at different caps—or pre-set price ceilings where the notes converted into equity. “When we went to convert them it meant that Excel couldn’t even calculate the logic,” Palmer says, “and we had to jump through legal gymnastics to reset everything in the A round. We were fortunate to have a really great group of investors—both noteholders and new equity investors—willing to collaborate and work through the challenges.”

Eric Paley, a partner at Founder Collective, says he has been seeing an increasing number of these situations: “Notes create some potential conflict with noteholders and new investors. Founders can find themselves caught in the middle.”

Some would argue that such mathematical problems are not artifacts of notes but rather how they are used, which is true. However, problems also arise because of the deliberately ambiguous nature of notes—they kick the can down the road on most of the major business items, particularly valuation, leaving a lot of room for interpretation or manipulation. “New investors often try to reinterpret the intent of notes in ways that are favorable to them. For example, note conversion is done before the creation of a new option pool instead of on a fully diluted basis,” Paley adds, which can mean a 10-20 percent difference in the value of founders’ shares. This Quora discussion gives a good flavor of the ambiguity around the issue.

The consequences of the deceptively simple convertible notes are not usually well understood. Here are seven things that usually surprise founders:

1. Little Value Add from Investors. Because the note converts at a set discount to the next round, investors have little incentive to help the company and may even suffer for doing so by paying a much higher price per share than they expected. Even if they can help provide connections for customers, partners, and key hires, why not wait to make them until the next round as long as the company won’t outright fail in the interim? While there is little upside, there also isn’t much downside since it’s a note and won’t lose value either. I’ve seen unmotivated, complacent investors so many times in these situations that I can’t count.

2. Reduced Incentives to Help. “Oh, but we have a cap.” Thanks, that’s great, maybe we have some alignment on building upside, but a note just with a cap lacks the right to invest in the next round. A major reason why professional seed investors make investments in very early stage companies is to invest more later. For a hot company—which is exactly the type of company seed investors want—there is a good likelihood that the next investors will want 100 percent of that round. Without a right to invest, the seed investor may not even know the round has occurred until they are mailed their share certificate after the note’s automatic conversion (yes, this has happened to us). Layering in a purchase agreement that includes this right and others solves this issue easily—and some people are productizing this form, such as the KISS Note (Keep It Simple Security) from 500Startups—but now the note is looking a lot more like an equity round.

3. More Preference. “You have $1M in a convertible note but it converts at a 50 percent higher price, so the preference increases,” says Bussgang. Preference is a debt-like feature of preferred stock that says the investors get their money back in preference, or before common stockholders get anything. Because many notes convert using a cap or at a discount to the next round, the amount of consideration for the preferred stock—and hence the liquidation preference—is greater than the principal in the note. (For example, if the company has sold $1M in notes that convert at a $3M cap and the equity round is at a $4.5M pre-money valuation, that $1M turns into $1.5M of preferred stock and hence $1.5M of preferences. If the company had sold the original investors preferred stock at a $3M valuation—instead of convertible debt—it would only have $1M in preferences.) That doesn’t matter if the follow-on rounds have clean terms and all goes well and the preferred converts to common in a successful exit. Where it comes back to bite founders is the mid-to-low outcome scenario where they pay out more preferences than had the money come in originally as preferred equity.

4. Less Discipline. Because notes typically lack governance provisions, these nascent companies usually lack experienced voices contributing to major decisions. “Sophisticated founders appreciate the rigor and discipline of having a board,” says Bussgang, “and notes postpone creating one.” Advisors can serve some of that purpose, but because they have less authority, they also are easier to ignore, or forget.

5. Two Words: “Full Ratchet.” We haven’t seen this term much in the past decade, so younger founders may have to use their favorite search engine to learn more. Ones who went through the “Great Tech Wreck” of 2001 quake at this term. So, that convertible note may have a cap, which is a ceiling, but it has no floor. A full ratchet is a nasty equity feature that says if there ever is a down round, the equity re-prices—in full—to the lower price per share. In other words, if a company raises $2M in a note with a $6M cap, they may think they have sold 25 percent of the company, but that’s only if the cap is met or exceeded. If the pre-money valuation on the next round is $2M; they have already sold 50 percent before the new money even comes in.

6. Deceptive Dilution. Unfortunately, there’s no data on whether notes are actually less dilutive for founders compared to doing an equity round. Managing dilution requires careful attention and regularly doing the math. “When you’re selling notes, you have taken on the dilution but haven’t mentally accepted it,” says Alex LoVerde, CEO of Wymsee. “It’s inevitable that there’s shock value.” (Disclosure: CommonAngels Ventures became an investor in Wymsee in its seed preferred equity round.) “Note structures also are more conducive to having a high volume of investors. It’s easy to add lots of people in small checks,” adds Bussgang. At CommonAngels Ventures, three times in the past year, I have been the first person to show founders their first pro-forma cap table with notes converting. In all three cases, they had “sold” nearly half of the company before the seed round. In one case, the CEO corrected me firmly, “No we haven’t!” So, I re-ran the numbers; OK, they had sold 42.5 percent. “Very few people who are using notes understand the mechanics of how they convert,” says LoVerde. “Almost no one checks the math.”

7. Lost Allies. Because convertible notes lack the information rights and right to invest in later rounds typical in seed equity instruments, they create situations ripe for disenfranchisement. Sadly, this can cost founders dearly later by losing their biggest allies. Let’s say the note investors convert to equity in the next round. The institutional leads for that round add a “Major Investor” clause that says various rights and voting only applies to them and not the “little guys” who were in the note. To be clear, there is no problem at this point since all is still well with the company. Several years pass, as well as several rounds of investment. If the company has the good fortune to have one or more acquisition offers, the founders may have an opportunity to make millions or even tens of millions of dollars. Those offers, however, may not fit the later, larger institutional investors’ business model. The first investors could be big supporters in the discussion about considering these offers, but they were pushed aside at the first equity round. Note: the CEO always has the right to include whomever they want, but I’ve been there when the big investors on the board direct the CEO not to do so. This leaves the CEO with a big challenge—to defy their main source of capital. But by making sure those note holders have these various rights, they can hide behind the provisions of the preferred stock and include early investors in the discussion.

Given all the above, why do so many smart lawyers let their clients—nay, often encourage them—to use convertible notes? There are several justifications, but one rarely said is that they work well with lawyers’ business models. High-powered lawyers work with startups for many reasons, including the intellectual stimulation and great founders, but a big one is to gain clients. Getting an established company to switch counsel is hard, so it’s a lot easier to pick them up when they are getting started. Those nascent companies, however, don’t have a lot of money and usually fail, so the economic incentive is for a successful lawyer to do an adequate job in as little time as possible. Naked convertible notes fit the bill—so to speak—quite nicely. That’s great for counsel; not so great for the company.

Reality is that all the seed preferred documents are available on templates. They don’t need to be a lot of work nor expensive. They can be done quickly. They can have a rolling close to allow companies to take money as they go. They do have marginally more legal work, including amending the corporate charter, but not necessarily a lot.

Notes, too, have their place. They can—and usually should—be used for the small, very early seed rounds if another round will come quickly, the economics are fairly clear and everyone’s expectations are in alignment. They also work well in bridge rounds between financings as a way to avoid potential conflicts of interest around pricing by insiders. But they are not as simple or innocent as they seem. Founders: consider the consequences—and work closely with experienced investors and counsel to use them wisely.

James Geshwiler is Managing Director at CommonAngels Ventures. He joined CommonAngels in 1999 and has been an active investor in mobile, cloud, consumer and business software as well as digital media companies. [Editor's note: CommonAngels is the lead investor in Xconomy.] Follow @geshwiler

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  • Michael Anderson

    This is a great article. I was recently asked by a few entrepreneurs if it was OK to bring an attorney in during their investor meetings to field questions about their funding documents.

    My answer was … absolutely not! This would clearly communicate the message that you don’t have a solid understanding of one of the most important contracts you are about to enter into as a company.

    Convertible notes are a good thing, but entrepreneurs and investors need to understand the the document line for line, in addition to, making sure there are some realistic terms within.

    • Better to PRETEND you know what you’re doing? Try to FOOL the other folks and make them THINK you’re smart about all legal matters when you’re NOT? An entrepreneur may know about drone technology or the Unified Field but may not know much about legal matters. Otherwise, why does he even NEED an attorney? Heck just use Legal Zoom….

  • Thanks Jay Parkhill and others for additional issues to consider:

    Number 8: When notes come due, the company often is insolvent. Investors are in charge, but don’t want to be. No one knows what to do.

    Number 9: Tax laws also say that reworking overdue Notes is equivalent to cancelling and issuing new Notes, so there are tax issues.

    Number 10: Notes lack the favorable tax treatment for Qualified Small Business Stock (sections 1202 and 1244 under the tax code), potentially reducing investors’ returns compared to equity.

  • To my lawyer friends who think I was too harsh: I’m not against notes, just their judicious use. It’s not bad practice to use them, and investors get why its easy to go with the flow and let clients use them…or even encourage them to use them out of good intentions given the assumptions when they are initially issues. However, then there are more notes, etc. and maybe if it were to be all done over again, it would be done differently…..

  • Marty Bauer

    Would also add in here the tax effect on the convertible note investors. Learned the hard way when we converted and an investor called to share the tax bill for the conversion. It was not a lost ally (to your last point), but an unhappy one.

    • Sam Iam

      Could you elaborate? In the ordinary case there should be no tax consequences and no tax bill upon conversion. Yours sounds as though it was not an ordinary case, but there’s not enough detail to determine what you might have in mind.

  • Sam Iam

    Almost every one of these points is exaggerated or misleading. The post also fails to consider that these considerations are pretty marginal if the convertible note round is limited to reasonable amounts (the larger the amounts raised relative to the eventual total valuation in a priced round, the more impactful most of these points become). 1&2: A discount and cap give more than sufficient incentive for angels to do all they can to promote the company’s success (and produce a higher valuation); angels are unlikely to be excluded from a priced round, particularly if they express interest in being included (many angels will not have the capital to double down anyway); 3: True this gives a bump up to angels, which (as pointed out in 1&2) they actually deserve. Putting aside that this point is in contradiction to 1&2, if the aim is to reduce angel returns, note terms can easily be adjusted to limit the preference to the actual amounts funded … This is only going to matter on an exit anyway, with the difference coming out of the common; 4: Angels are typically too scattered and uninvolved to play a role in formation of a board, this is not going to change if you give them equity; convertible note terms could require a board, but at such an early stage and with small and fragmented investors, likely it would simply be dictated by the founders anyway; 5: Any company that raises large sums at valuations that can’t be supported in subsequent rounds (including many of today’s unicorns) is going to be in the same boat, and rightfully so; 6: Failure to keep track of your cap table is hardly an indictment of convertible notes; 7: Note terms could easily include information rights, though the premise is that the nature of smaller and fragmented angel investors does not lend itself to deep involvement in the day-to-day; 8: In the event of a payment default, the founders write a letter to the investors requesting approval for a waiver of the payment default (typical), or proposing a liquidation and distribution of the proceeds, this is not complicated, and dealing with many small unsophisticated equity holders is also going to present situations where the equity holders have no idea what they’re doing and don’t appreciate the demands put upon them; 9: Presumably this refers to cancellation of indebtedness income (the borrower must count as taxable income the amounts of debt forgiven in the haircut). In such a scenario the company will have plenty of losses (it failed to generate enough profits to pay off the notes after all) to deduct against any such phantom income, and anyway noteholders aren’t going to negotiate for a lower principal balance on the notes, they’ll likely flip into equity at some mutually agreed price and ride out the storm with the rest of the common shareholders; 10: SAFE/convertible equity/KISS notes receive Qualified Small Business Stock treatment, an argument in favor of this convertible note variant. Bottom line: These are considerations founders should be aware of, none really mitigate against using convertible notes, and omitted from the discussion is a quite long list of pitfalls of trying to do a priced round at an early stage with a large number of unsophisticated angels.