Convertible note · Fundraising

Are convertible notes a turn-off for investors?

Varun Gupta Sr. Front-End Developer at Code Brew Labs

March 13th, 2017

Right now our startup is bootstrapped and we want to bring in some money to add more users and implement some revenue options for our business. We really like the idea of convertible notes because we can close this quickly and inexpensively while not giving away equity and control right now. Will we find investors interested in this financing structure? Or are investors turned off by convertible notes?

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Hanna-Maria Ahonen dancer/accountant/consultant & then entrepreneur

March 13th, 2017

Hi, In my experience, start-ups are better off leaving convertible debt to the very last round before selling the company. Fred Wilson also re-posted today his response to this question from his earlier MBA Mondays series. I hope this Fred's (longer form answer) is helpful to you;

"Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.

For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.

Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.

The typical forms of compensation for making a convertible loan are warrants or a discount.

Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of “warrant coverage percentage.” For example “20% warrant coverage” means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let’s say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.

A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let’s use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.

Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.

Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company’s life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I’ve purchased and I do not like taking equity risk and getting debt returns.

However, later on in a company’s life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.

My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender."

Ran Fuchs Senior executive passionate about new tech.

March 13th, 2017

Actually, at angel stage convertibles are a great, if not the best way to go. Most angels in the USA are familiar with them, and I have never had any problem using them instead of equity. The issue is not equity control. Nobody will take control from you at the seed stage. The main advantages, are legal cost and the fact that you do not need valuation

Andy Freeman Product Management and ... - Looking for new opportunities

March 13th, 2017

It depends. Are the proposed terms a good deal for investors? Are you offering a significant discount? How much interest? A good cap? When is the conversion likely to happen?

A convertible note basically asks an investor to pay today, taking today's risk, in return for stock whose price is set when the risk is lower and the business is more valuable. (Both factors lead to higher stock prices.) Do your terms make that tradeoff a good deal for potential investors?

Brandon Brown

March 13th, 2017

if you have a clear path to series-A and are confident you can deploy the capital to dramatically grow your value, then conv. notes are a good idea. you get into trouble when you end up raising a priced round down the line at a valuation much lower than your cap and you haven't agreed on a price minimum. in this scenario, the investors still get a discount on the lower price. if the note is structured in such a way that their entire investment now converts at this price + discount they can end up owning 2x or 3x the original/anticipated equity with no additional capital.

if you have the ability to price your round, do it. if you really think the capital today will skyrocket your growth before the next financing, then go for conv. debt. but imo, if you have the option, you should default to a priced seed round.

Adam Pressman

March 13th, 2017

Not sure about investors but there's a lot more to think about convertibles. We like revenue royalty deals as they tend to offer better control for the entrepreneur and a faster return of investor funds, albeit not often as high an ROI. The rub is you have to have revenue and significant enough margin to afford, say, a dime on every dollar going to your investors.

Dane Madsen Organizational and Operational Strategy Consultant

March 14th, 2017

It is fast, cheap, and easy to do. Disregard all the comments about it being a late stage tool - those are confused with traditional convertible bonds or preferred and their application. Angels like notes, and seed VCs will tolerate them. They will be gone before a Series A is in place so has no bearing on later stage VCs.

Daniela Entrepreneur, tech lover, Crowdfunding advocate

March 13th, 2017

Many Angel investors nowadays prefer convertible notes, specifically when it is hard to set a valuation because the startup is very early-stage.

David Collette If you don't have a profit model you have nothing.

March 13th, 2017

Convertible equity is the way to go as it's a simple document that requires very little negotiating with your investor and is cheap to execute via a lawyer. Unless you have revenue, are a going concern, know how to value your business, and believe your potential investors will agree with you just punt the problem downstream. Totally acceptable thing to do. Visit Y-combinator for their SAFE document

Heather Holst-Knudsen CEO & Founder, HatchPad

March 17th, 2017

I have to agree with Brandon. If you have a clear path and the needed team in place to move to a Series A round in a reasonable amount of time, then a convertible note is something to consider. If you do not have a clear path, then using a note can put you in a very bad spot when the note is due. There are also some very valid issues that Hanna-Maria brings up and I would definitely read what Fred Wilson has written about this in his blog.