A Note on Notes: Hidden Costs of Convertible Notes
It’s been really exciting to watch the explosion of startup activity the last three years. This expansion has been characterized by technology infrastructure shifting from fixed cost to variable, proliferation of seed funds and accelerator programs, exit markets opening and other factors.
A byproduct of this increase in seed investment activity is the wide use of convertible notes. I am all for structural innovation, but I believe that the use of convertible notes has drifted away from the original purpose, and this shift is a bad thing for founder and investor alike.
Convertible notes used to be called bridge notes, and they usually served a specific purpose to finance a company for a limited period of time (3–6 months) to complete a financing under termsheet, or achieve a major milestone so that the next round would be easier to raise and/or at a materially higher valuation. These notes were often done by insiders and did not have a capped valuation, for fear of signaling to a new investor what the valuation of the company might be. This was especially true because the period of time before that subsequent financing was pretty short. Notes came with a 20% discount, and because the maturities and time outstanding was usually short, this juiced the return on the notes to compensate investors for the risk of a subsequent financing not occurring.
Convertible notes evolved and became a prevalent way to finance a seed stage company. These notes were larger amounts than bridges, and also featured longer maturities, with a subsequent financing being more unknown. I think there were three primary drivers for this: (1) the founder and investor did not have to negotiate a valuation, particularly at such an early stage when the company’s valuation is the most subjective and difficult to determine and (2) it was much less expensive legally to implement a note financing and (3) this method almost always is better for a founder, since a 20% discount to a future yet-to-be-determined price is unlikely to compensate an investor for the risk. The 20% is fixed, and if a note is outstanding for a year or more, the 20% doesn’t scale and the price of the next round is likely to be higher. Consider a bridge over 3 months that gets a 20% discount, which is equivalent to 80% annual return (not including interest). A convertible note round that lasts 18 months is more like a 13.3% annualized return. Yes, a company that has more capital is less risky, but it’s less risky to lend to a company that has a relatively certain approaching financing event, why should that get a higher return? Interest does scale naturally, but the low rates means it is not the way to compensate for risk.
There are other more minor factors that work in favor of the founder, including that investors do not have shareholder rights and typically do not join boards of directors as note holders.
One of the elegant things about venture finance is that in a typical equity financing, incentives are generally aligned between founder and investor. I say generally, because liquidation preferences allocate proceeds at “low” sales disproportionately, but for most decent outcomes, investor and founder incentives tend to converge.
But in a convertible note financing, incentives are opposed. Founder has a strong incentive for the next round to be at a very high valuation. There is a double benefit here: new capital will be less dilutive and the early note capital that will convert will also be less dilutive. It’s like bowling a frame after a strike. You know that this frame has a multiplier effect on the prior frame in addition to the current frame. But the note investor is in an awkward position. Every investor wants his/her companies to succeed. But as the company makes more progress, slaying risks and propping up potential rewards, the investor sees the price they are paying increase. The reward for taking an early risk on the company is a retroactive price increase. So if you reduce everything down to the carnal essence of financial incentives, the investor wants the company to do well enough to attract a financing, but not so well to have a large run up in price. So consider an investor, sitting at his/her desk with a great introduction to make to the company that they know could cause them to pay a much higher price on funds invested a year ago or longer. A good investor still makes that introduction, but at the essence it’s perverse.
This disconnect is largely due to an investor taking a specific risk at a specific time for an unspecific price. A price that the investor can influence. I can’t think of other markets where this occurs.
About three years ago, the concept of a conversion cap emerged. It’s a maximum share price at which the note would convert. This addressed the issue of a valuation run-up. Investors were protected by virtue of this cap, and that alleviates some of the misaligned incentives, but not entirely.
When a company raises capital at a price higher than the note, investors rejoice, but it doesn’t mean they were compensated for the risk they took. Furthermore, it requires that a cap is negotiated, which defeats one of the primary benefits of a note in the first place. The cap becomes a signaling mechanism and in some cases may limit the eventual valuation placed on the company. Then notes got structured to capture upside, with provisions that multiplied the payoff if the company was sold before the note converted to equity. It’s more often now that I see absurd over-engineered notes that essentially are priced equity.
It is true that the use of notes has resulted in financings occurring that otherwise wouldn’t have. It might seem like a good thing for founders, but when incentives aren’t aligned with investors, and when investors aren’t compensated for the risk they take, it can harm the ultimate outcome of the company. Plus, maybe some of these companies shouldn’t be funded in the first order.
This theoretical argument may not be enough to compel founders to choose equity over notes to seed their companies, or investors to invest in seed deals to buy “access” even at inflated prices. As the terms have evolved though, founders choosing the note path are really issuing synthetic equity, so maybe we should all go back to doing true equity in the first place.