Founders Beware: Convertible Notes Can Eat Your Lunch
The increasingly common Convertible Notes and SAFEs (Simple Agreement for Future Equity) have been used to help tens of thousands of startups raise capital. They work quite well when used appropriately, especially for early-stage companies raising anywhere from a few hundred thousand dollars to a million or slightly more. These notes benefit the investor, as they include valuation protections (via valuation cap and discount), offer seniority in the capitalization structure (e.g. first-in right of payment), and are easy and cheap to draft. Moreover, they allow the startup to quickly raise capital without having to commit to a firm valuation (although I’d argue that there is a strong correlation between valuation caps and the price of a subsequent equity financing that is raised within a reasonable period of time from last note issuance).
While raising notes in Angel and Seed rounds can save the founder some equity prior to his/her Series A, the note can be a double-edge sword.
For a brief refresher on the mechanics of notes, here’s a good reference. I’d also recommend reading Fred Wilson’s thoughts on the matter here.
One problem we’re seeing more often is outstanding convertible notes adding an artificially high amount of liquidation preference to a company upon conversion in a priced round. Unless there is specific language stating otherwise, the entire principal (and accrued interest) of notes converts at the lower of (a) a price per share based on a pre-money valuation using the Valuation Cap, or (b) a discount (usually 10–20%) to the price per share paid by new equity investors.
The bigger the delta between a Valuation Cap and the pre-money valuation on a subsequent priced round, the bigger the liquidation preference.
While this may be considered a small nuance, it can actually have a very large impact on a company down the road.
Here’s an example (and here’s the model to play with):
- Company raises $2M of convertible notes at a $6M cap (a great seed round)
- Company then raises $10M at a pre-money valuation of $42.5M (a great Series A; side note: I am using this pre-money valuation because it gets the new Series A investor 15%, which you will see later)
- Assume there are 10M shares outstanding on the pre-money capitalization; assume the new equity carries a standard 1x liquidation preference
Here’s what happens:
- $6M (cap) divided by 10M (shares) = $0.60 per share (the conversion price per share) → So $2M of notes (assuming no accrued interest) divided by $0.60 per share = 3.33M shares.
- $42.5M (pre-money) divided by 10M (shares) = $4.25 per share (price per share paid by new investors) → So new investors get $10M divided by $4.25 per share = approximately 2.4M shares.
Unless the docs state otherwise, noteholders are getting 3.33M shares of preferred stock with a liquidation preference of $4.25 per share. So 3.33M shares times $4.25 per share = $14.2M of liquidation preference, or 7.1x the total principal of notes!
Why does this matter?
While we’d like to think that a company that raises a $10M Series A at a $42.5M pre-money will scale to be a success and sell for a lot more, this unfortunately doesn’t always happen. We’ve been early noteholders in companies that have grown to be industry leaders, and we’ve been early noteholders in companies that have not. For the latter situations, it can often times be painful for an entrepreneur who is looking for a “soft landing” to sell the business.
In our example above, the company has $14.2M of liquidation preference from noteholders, and an additional $10M of liquidation preference from Series A investors, for a total of $24.2M. That means that if the company is sold for less than $24.2M after the Series A, the founders (common shareholders) won’t see a penny. (Now, the inverse is true that every dollar above $24.2M would go to the founders until the exit price exceeds the post-money on the Series A round, after which proceeds would be shared pro rata based on ownership).
So, simply put: our theoretical company that raised a total of $12M ($2M seed plus $10M Series A) has to sell for over 2x that, or $24.2M before the founders make any money.
This may seem immaterial, as the company is clearly doing something right when an investor wants to put in $10M. And that may be true…until it’s not.
On a similar train of thought, another thing I see is founders looking to raise capital at the highest valuation possible. Remember — what matters is dilution, which factors in both capital raised and valuation. A company that raises $10M at a $66.7M post-money valuation (as in our previous example) will incur the same dilution as a company that raises $20M at a $133.3M post-money valuation — the only differences being that in the second scenario, (a) optically it looks awesome, (b) the liquidation preference has increased because of the additional $10M invested in the Series A, and most notably, (c) with our example above, the liquidation preference on outstanding notes will increase linearly.
As you can see from the chart above, as the valuation of the priced round rises (regardless of the amount being raised), so too does the liquidation preference from the notes converting. As I mentioned earlier, the bigger the delta between the valuation cap on notes and the pre-money valuation on the subsequent priced round, the bigger the liquidation preference.
In our first example, the company that raised $10M at a $42.5M pre-money valuation had a post-money valuation of $66.7M: $42.5M (pre-money) + $10.0M (new money) + $14.2M (value of converted notes), and the founders incurred a total dilution of 36.2%.
Now let’s look at the new scenario, where the company incurs the exact same total dilution, raising $20M at a pre-money valuation of $85M. In this scenario, the post-money is actually $133.3M! This is calculated as: $85.0M (pre-money) + $20M (new money) + $28.3M (value of converted notes).
What just happened? The company that raised $22M now has a liquidation preference of over $48M. This means that the founders (common shareholders) won’t see a dollar if the company is sold for less than $48M.
What’s the Point?
Simply put, if you raised $2M in a priced round at a $6M pre-money, and then raised $10M in a priced round with the same $66.7M post-money for the same 15% of the company, you would end up with a total liquidation preference of only $12M. This helps founders in that they will participate in the proceeds of a sale starting at an exit of over $12M (versus $24.2M in the first notes example). While this may seem insignificant, as I illustrated above, it can become very impactful as the delta between the valuation cap and the pre-money valuation on the subsequent equity raise grows.
I would argue that if a company is raising more than ~$1M, they should raise with equity rather than notes. While it may add slightly to the dilution incurred by founders (two rounds of dilution for a total of 40% dilution in the equity only scenario versus one round of dilution for a total of 36.2% in our first notes example), it simplifies the cap table, reduces the underlying liquidation preference, and generally makes it easier to complete a Series A for a number of reasons; one of them being that Series A firms typically invest $5–10M for 15–20% equity. Making this math work for the Series A investor (using our example above) can thus be very challenging and add complexities to the deal.
Practicality is key. It’s easy to be persuaded by the simplicity and the few extra points that a note may offer, but you may be adding material complexities to your capital structure that make future funding, or exiting, more difficult.
At Indicator Ventures, we always support our founders and whatever they feel is best for their company. At the same time, we want to make sure our founders are acutely aware of the economic impact whenever they look to raise new capital.
I hope this article helps shed some light on the impact of commonly used, but often misunderstood convertible notes. I’d love to hear your thoughts below!
