Why Entrepreneurs Should Avoid Convertible Notes
Brett Munster
As an associate that does a lot of the heavy lifting behind the scenes in gathering due diligence, writing detailed internal investment memos and putting together cap tables for the various deals we have done, nothing has caused me more headaches than the proliferation of convertible notes. I have talked with a number of experienced investors about the subject and all have told me that even five years ago convertible notes were not nearly as prevalent. Oh how I wish that was still the case. Today, convertible notes are far too common in my opinion.
In my experience, most entrepreneurs do not fully understand the terms of a convertible note. As a result, when the next round of financing occurs and I have to walk them through the implications, I can see the “Oh Shit” look forming on their faces. Too many entrepreneurs are so eager to raise money quickly that when an early investor suggests a convertible note structure they just accept it. Many entrepreneurs have never raised a convertible note before and are typically dealing with much more sophisticated investors setting the terms. As a result, the entrepreneur ends up screwed when he raises his next round. To be clear, I do not think most angel investors are predatory but they are trying to protect themselves and that short sightedness often hurts the company later on.
Why are convertible notes so prevalent these days? Primarily because the parties involved can avoid the valuation question. There are standard ranges of interest rates and discounts that most notes have and so it simplifies the process of raising money by kicking the valuation discussion down the road. Consequently, the negotiations are often much faster. Lastly, legal fees often times are less for a convertible note than a typical round.
So convertible notes often means that entrepreneurs are more likely to raise the money they need and it will take less time so they can get back to building that world changing business. Sounds great right? Not quite. For one, avoiding that valuation discussion has serious consequences later on. Second, entrepreneurs often do not fully understand the implications of the terms in a convert. I will try to highlight the most common issues I have experienced.
The first, and by far the greatest, source of frustration with convertible notes is the valuation cap. While the cap seems harmless at the time of investment, by the next round it is often grounds for contention and delays the financing. Valuation caps exist to benefit the investors and no one else. Not the company. Not the founders. Not future investors. The cap limits the price per share the convertible note investors will pay in the next financing. Sounds harmless? Not when you realize the potential implications.
First, that valuation cap essentially puts a ceiling on the price of the next round. New investors do not want to pay anything higher than that artificial cap. Why? Because the note investors will pay a lower price per share than everyone else and thus will be given a disproportionate number of shares. If the note converts post-money, I as the new investor, immediately suffer dilution. That means if the valuation of the round is higher than the valuation cap of the note, the moment I invest, my investment is worth less than what I paid for it. And the amount of dilution the new investor takes on immediately is exacerbated by the valuation cap. Therefore, most investors negotiate to have the note convert pre-money.
If the note does convert pre-money, guess who takes on all the dilution? That’s right, the entrepreneur. The greater the difference between the cap and the round’s valuation, the more dilution the entrepreneur suffers. I as a new investor do not want this either. Personally, I believe that if a company succeeds, that entrepreneur deserves to have a big payday because he or she took the greatest risk and did the most work. I also want the founder to own a considerable percentage of the company because I want him to stay motivated. To make matters worse, most angel investors do not add much value to the company. If they have a disproportionate amount of stock and are not actively contributing, that does not sit well with me. I want people on the cap table “earning” their ownership, including me. Yes angel investors deserve something because they invested earlier and presumably took more risk, but that is what the interest rate and discount rate are for.
The above dynamics make it hard to raise an equity round at a valuation higher than the valuation cap. If an entrepreneur absolutely kills it after raising a convertible note, she may have a hard time getting the valuation she deserves and thus will take more dilution than she should in the next round. This is exactly the scenario we had with one of our companies. We did not want that to happen to the founder and we had to go back and renegotiate the valuation cap. That negotiation was not easy and is not always possible. Hence, I would like to see the valuation cap eliminated in convertible notes.
A second common problem is that many convertible notes are ambiguous as to whether they convert pre-money or post-money. Brad Feld observed this as well. Most VCs, myself included, assume that convertible notes convert pre-money as that is industry standard. However, I made the mistake of not asking during one of the first deals I ever worked on, and did not find out until near the end of the process that it actually converted post-money. It becomes a point of contention and puts the entrepreneur in a tough spot between his current investors and new ones. Anytime I see a convertible note, this is the first question I ask. Advice to any entrepreneur reading this, define it clearly in the convertible note that the note converts pre-money and save yourself a ton of hassle later on.
The last issue is the least obvious and the least well understood. There can be a situation in which the note investors get excessive liquidation preferences, sometime up to 3x or 4x, if the next round is raised above the valuation cap. The language in the convertible note does not make this explicit and very few entrepreneurs realize excessive liquidation preferences are a possibility until it is too late. To be honest, I hadn’t realized this until I saw it firsthand. Mark Suster has an excellent post about a month ago about this phenomenon and how to avoid it. Please read it, understand it, and implement the language Mark suggests.
As I am sure you can tell by now, I highly advocate doing a priced round whenever possible, even very early on. However, there are times that a convertible note does make sense. The best situation is an insider only round that bridges the company to its next financing. This allows another investor to value the company in the next round without being impeded by the most recent financing which may have been a down round since the company needs. Also, because all the note investors already invested in the company, they are not trying to take advantage of the company but rather, help the company get to a more healthy point which are very different motivations than an outside investor drafting terms for a convertible note.
