The Definitive Guide to Convertible Notes in Startup Investing

 
 

Convertible notes have received great praise and much criticism in the last few years.  When done right, convertible notes can be very beneficial to both startup companies and angel investors.  However, thee are a lot of pitfalls for both the angel investor and for the startup, so it is important to get it right.  This guide will answer a number of questions including:

  1. “What is a convertible note?”
  2. “What is the history of the convertible note and how have convertible notes been used successfully in the past?”
  3. “What are the benefits and drawbacks of a convertible note?”
  4. “How should convertible notes be used and is it right for me?”
  5. “How do I evaluate the terms of a convertible note?”
  6. “How do the cash flows of a convertible note work?”
  7. “What documents do I need when negotiating, finalizing and executing a convertible note financing?”

1) What is a Convertible Note?

Convertible Notes, also called Convertible Bonds, are a type of financial security that mixes a debt security with an option to convert the outstanding balance to equity at a predetermined time.  In startup financing, convertible notes are typically used in financing early stage companies without the burden of creating a valuation for the company.  This makes it a relatively fast and easy way to invest in a startup, because there are fewer terms to negotiate.

Example:  If Widget Co. is raising $250,000, they will reach out to investors who will provide the capital in exchange for equity or debt.  At this point, if the investor does not know what Widget Co. is worth but she still wants equity, she can elect to receive convertible notes which behave like debt until she is ready to convert to equity at a later date.  In this case, if the investor takes convertible notes, it will be recorded as debt for the company, and will accrue interest until it is paid or the outstanding balance (principle+interest) is converted to equity.  Typically, an automatic conversion will occur at a specific milestone such as the close of the next funding round.

While convertible notes can be much faster to finalize than an equity transaction, it can still be very complicated.  Convertible notes can vary in interest rate, maturity date, payment terms, conversion caps, liquidation preferences, warrants, pro-rata rights, along with a host of other special clauses that can complicate things.  For this reason, it is important to fully understand every clause in a convertible note so that you can ensure that any convertible note transaction is fair to both parties.  


2) The History and Past Successes of the Convertible Note

Convertible notes have been around for a long time, and is essentially the foundation of the initial standard currency within the Americas.  In 1640, the first recorded convertible note came with the first primitive American banks, called Land Banks.  These banks made loans by issuing notes that were secured by real estate from the borrower.  The Borrower use the land bank’s notes and its credit to purchase the property.  Subsequently, due to a lack of currency, The Fund bank in Boston was created to issue private notes that were payable in currency but secured by the underlying land assets.  These “bank notes” could be converted to a share of the underlying asset in the case of bank default.  New Jersey was the first to begin circulating “bank currency” using this method in 1723 and similar currencies began circulating in other colonies within the following 7 years.  Subsequently, banks began to offer other asset backed notes such as silver and gold, which could be converted to the underlying asset on demand. 

In the 1860’s, the first convertible note with for underlying company equity was created by a stock market speculator called Jacob Little. Little would take large short positions in companies coupled with convertible debt to create a price floor.  If the stock value were to rise significantly past what Little could cover, he would convert his debt to equity at a fixed price and cover his liabilities, if not, he would make a killing.

Fast forward to the early 2000’s where convertible bonds were used for many different applications in the banking world and just began to enter the startup funding space.  The initial application for convertible debt was for startups who were in between funding rounds but needed a little boost to get them to their next round.  The convertible note was perfect for this application because it could offer short term financing without the high legal fees and long negotiations associated with a funding round.

As investors discovered the transaction ease of purchasing convertible notes for bride loans, they began to contemplate the application of convertible notes for longer term raises such as seed rounds, where the company does not have enough operating history to justify a valuation.  This convertible note purpose is where things can get messy.  When convertible notes are issued with a long term expected duration, they begin to act more like debt securities rather than equity, which can hurt the company.  They also cause huge risks to investors, due to the possibility of significant valuation swings.  There are convertible note terms that can help control for these issues, but they can complicate the easy nature of the convertible note bridge loan.

The verdict on convertible notes is that there is a time and a place.  Paul Grahm from YCombinator proclaimed that convertible notes were the way forward for seed round financing which has sparked a substantial debate (Debate Summary).  Additionally, at the beginning of 2015 Uber completed a $1.6 Billion convertible note deal fundraising round with some large institutional investors.  While surprising, it is clear that there is an application for convertible debt, it is not right for everyone.


3) Benefits and Drawbacks of Convertible Notes in Startup Financing

Convertible Note Pros:

  • Convertible notes are much faster to issue than equity for a number of reasons.  First, convertible notes do not require a specific valuation negotiation, which tends to delay equity deals.  There is also typically less paperwork to create for convertible notes, which helps speed up the transaction and to reduce any associated legal fees.
  • Convertible notes do not require specific rounds of financing.  If a company is unable to stay afloat between financing rounds, they can issue convertible notes to keep them afloat. 
  • Investors receive some, though minimal, downside protection on their investment.  If a company defaults prior to note conversion, the investors will be considered debt holders instead of equity holders and will receive the associated debt holder liquidation preference.
  • Since convertible notes are issued prior to the financing round in which they convert, they tend to be issued at a lower valuation.  To adjust for this, note holders typically receive a renegotiated discount on the company valuation at the time of conversion.

Convertible Note Cons:

  • The next round of investors may not like the idea of paying significantly more than the convertible debt investors paid per share.
  • Having a discount on the conversion value of convertible debt helps, but there is still a risk that even with a discount, the conversion percentage does not accurately reflect the risk of the initial investment.
  • Convertible note investors do not appear directly on the capitalization table before conversion.  This can confuse future investors who are valuing their contribution as a percentage of the company (Shares owned/Shares outstanding = % ownership).  When the note converts, it will add additional shares to the denominator, thus immediately diluting a future investor’s ownership of the company.  This can cause investors to shy away from a potential deal.  The larger the outstanding convertible debt value, the worse this problem gets.
  • Convertible notes typically convert at the same terms of the future deal, which could be significantly different from the terms that the investor would get when they make their investment.  This can be a risk in both directions.  The initial investor maybe able to negotiate preferred shares when he makes his investment, but the subsequent round may only provide common shares, or vice versa.
  • Convertible notes are very flexible to additional clauses and terms.  For this reason, additional clauses can significantly change the value of issuing or receiving convertible notes.  See our terms section below.
  • If the convertible debt executes automatically, the investor does not have any control over the terms of her equity assets.
  • If convertible note caps are set too low or if valuation floors are set too high, it will cause a disproportionate dilution to both the founders and investors.  Additionally, negotiating conversion floors and caps can defeat the purpose of using a convertible note in the first place, as it requires a valuation negotiation.
  • Finally, convertible notes are a debt asset, which means that it appears on the startup’s books as a liability and they typically include an interest rate.  This puts an additional burden on the company, and it hurt the company’s ability to raise subsequent money from investors and bankers.

4) When are Convertible Notes Used, and When Should They be Used?

These days convertible notes are used to all types of financing.  They are used for long term and short term financing, in both early stage and late stage companies.  Really the only common thread in convertible bonds is the aversion to assign a specific valuation to the company.

Long Term Convertible Note Financing

In the last few years financing through convertible notes has become extremely popular.  It has occurred in a variety of company stages but it is most common in seed stage companies.  This is due to the inherent uncertainty of a company valuation at the earliest stages of the company.

This type of financing should only be done in the earliest stages of the company when there is not a clear value of the company and any stock earned from investing would only serve to disincentive the founders.  Most of the major pitfalls listed in the pro and cons section occur due to long term convertible note financing.

Short Term Convertible Note Bridge Financing

Convertible Notes in Startup financing originally began as bridge financing for later stage companies and is the ideal application for convertible notes.  Short term bridge financing is the use of convertible notes in between rounds of funding to get the company to their next funding round due to a short term liquidity issue for any number of reasons.  While convertible notes were originally reserved for late stage companies, now they are used across the board to help companies get to their next funding round, whether that be an IPO or a Series A.

The short term bridge financing application is the ideal use of the convertible note.  Most of the major convertible note pitfalls occur due to a long maturity which can exacerbate many of the risks associated with a convertible note, such as valuation shifts and firm insolvency.  Further, the benefits of the convertible note, such as the ease of transaction and the low legal fees exist in the short term maturity application.  

Should I Use Convertible Notes?

While there is always an exception, you should be considering a Convertible Note if:

  1. if it is in the structure of a short term bridge loan
  2. if you are in a very early stage company that cannot be valued by common valuation methods
  3. if your investors are insisting on a convertible note and you're out of alternatives, it is usually better to take a convertible note rather than loose the company

Otherwise, convertible notes tend to be disadvantagous to both the startup and the investor.


5) The Terms of a Convertible Note

For most applications of convertible notes, it is better to keep it simple.  The key terms to keep note of are the conversion discount, the interest rate, and the valuation cap.  When evaluating the note, make sure these three terms are within the industry norms stated below.  We recommend staying away from warrants and other clauses in a convertible note that can complicate and lengthen the transaction, as the advantage of using a convertible note is the ease of transaction. Finally, we recommend running any prospective agreement through a lawyer prior to closing.

Conversion Discount (Discount)

In startup financing, conversion rates for convertible notes are typically dependent on the company valuation at the time of the next equity financing round.  To compensate for the additional risk associated with financing the company at an earlier stage, the convertible note typically converts at a lower valuation, or discount, to the valuation decided at the following financing round.  For example, a 20% discount would be a price equal to 80% of the price per share paid by the following rounds equity security investors. 

Share Count = Outstanding Note Balance/ (Conversion share price x 0.8)

Typically discount rates are between 10% and 30%.

Valuation Cap (Cap)

The valuation cap is essentially a valuation ceiling on the convertible note.  It prevents the conversion rate from increasing well beyond where the investors risk would adequately compensated. 

For example, if an investor invests $100,000 in a company that he believes to be worth around $1M but the entrepreneur believes its worth closer to $5M, they may decide to forgo the valuation in lieu of a convertible note.  If the investor receives a convertible note at a 20% discount and the company does well and the next valuation is stated at $10M, the investor would convert at an $8M valuation which is far higher than the initial valuation of the company when the investment was made.  A valuation cap would help prevent this by defining a limit to the valuation increase. 

If there is both a Cap and a Discount in a convertible note, the note typically specifies that it will use the more beneficial term when calculating the conversion rate.

Warrants

Warrants are essentially options to purchase equity at a specified price in the future.  The only difference between a warrant and a stock option is that warrants are company issued and the equity that is purchased is issued by the company and does not come from currently outstanding shares.  

In startup financing, we typically see warrants as a replacement for the discount rate in convertible notes.  For example, if an investor were to receive a 20% discount on a $100,000 investment for the next round of financing, you could replace that discount with $20,000 in warrants, which roughly means the option to buy $20,000 worth of shares at a specific price (strike price). 

There are a number of ways to determine the strike price for a warrant, but the most common are: 1) the price per share of the last common share financing round, 2) the price per share of the last preferred share round, or 3) the price per share of the next preferred share round.  This tends to be a big negotiation point as it can significantly change the amount of shares outstanding. 

Additional items to be aware of for warrants are the term length and the “original issue discount”.  Term lengths are straight forward, it is now long the warrant is convertible before it expires.  Typically warrant term lengths are 5 to 7 years where the entrepreneur wants it to be shorter and the investor wants it to be longer.  The Original Issue Discount (OID) is a tax consideration on the investor.  Essentially, the IRS considers warrants to have an intrinsic value outside the value of the convertible note.  If warrants are issued without a minimum payment (typically totaling thousands of dollars) they are considered gifts and are taxed accordingly.  This is a complicated issue that should be discussed with an accountant and a lawyer. 

Investors do not typically prefer warrants over discount rates but warrants are far more complicated than discount rates and cause additional legal fees for the convertible note.  We recommend staying away from warrants unless there is no other choice.

Equity Interest Type

Equity interest type is the type of equity a convertible note will convert into, either common shares or preferred shares with additional control rights.  Typically equity interest type is not a tough negotiation point and convertible notes convert at the same equity type as the next funding round.

Interest Rate

Convertible notes are debt instruments and so they typically carry interest rates associated with the investment.  In fact, in the United States, if there is not a minimum interest rate associated with a loan it is considered a gift, so an interest rate that is equivalent to the current treasury rate plus a buffer of a few percent is necessary to prevent taxes.

Typically the interest rate is between 6% and 12%.

Maturity Date

The maturity date is the date on which the loan becomes due is there has not yet been a conversion.  Typically maturity dates range from 12 to 24 months, by which time a funding round must be completed to prevent reaching the maturity date.  If the maturity date is reached before conversion the bond becomes due which can lead to default for the underlying company.  An automatic conversion can fix this issue, but sophisticated investors will not typically allow such a provision to enter the convertible bond.

Repayment Terms

Repayment terms are always stated in a convertible note and typically reserve payment until the maturity date.  This allows the company to abstain from payments if there is a conversion opportunity, but it also causes a large liability to remain on the books.

Other

There can be many other one off terms listed on a convertible note, we have covered the most common terms above.  Make sure to thoroughly evaluate any term that is listed on a convertible note as it can change the value of the note significantly.


6) Convertible Note Examples

Example 1: $100k note with a 10% Annually Compounded Interest Rate, 20% Discount, no Cap

A Series Seed convertible note was issued for $100k without any valuation cap and with a 20% discount.  One year later at Series A the note is worth $110k with interest added in, and the company is valued at $5M at $10 per share.  To calculate the number of shares the note would convert to:

(Outstanding Note Amount )/ (Share Price)x(1-Conversion Rate) = Shares

$110k/($10*.8)=13,750 Shares

On paper, 13,750 shares are worth $137,500, which is a 37.5% gain on the $100k initially invested.

 

Example 2: $100k note with a 10% annually compounded interest rate, $8M Cap, no Discount

A Series Seed convertible note was issued for $100k with a $8M valuation cap and no discount rate.  One year later at Series A the note is worth $110k with interest included, and the company is valued at $10M at $20 per share.  To adjust the share price to the cap, we need to multiply the share price by the quotient of the cap and the valuation price:

($8M/$10M)x$20=$16

Next we divide the outstanding note value by the per share price to find the number of shares outstanding.

$110k/$16= 6,875 Shares

On paper, 6,875 shares are worth $137,500 which is a 37.5% gain on the original investment of $100k.

 

Example 3: $100k note with a 10% annually compounded interest rate, $5M Cap and 20% Discount

If a convertible note has both a cap and a discount, the note typically states that it converts using the term with the lower company valuation.

A Series Seed convertible note was issued for $100k with a $5M cap and a 20% discount.  One year later at Series A the note is worth $110k with interest included, and the company is valued at $10M at $10 per share.  To determine which valuation would be lower, we must compare the 20% discount to the $5M cap.  

($10M current valuation x (1-20%))= $8M discounted valuation

$5M cap < $8M discounted valuation

Since the $5M cap is less than the $8M discounted valuation, we'll use the cap as the conversion term.  To adjust the share price to the cap, we need to multiply the share price by the quotient of the cap and the valuation price: 

($5M/$10M)x$10=$5

Next we divide the outstanding note value by the per share price to find the number of shares outstanding.

$110k/$5= 22,000 Shares

On paper, 22,000 shares are worth $220,000 which is a 120% gain on the original investment of $100k.


7) Appendix (Sample Documents)

At DunRobin, we're fans of the open source documents provided by techstars.  There is a convertible promissory note purchase agreement, which sets for the agreement relating to the note, the actual note, and the associated term sheet.

When using these documents, remember to adjust it to match your needs and have them reviewed by a lawyer before executing the agreements.