PS#025: Convertible Notes
Let’s chat about convertible notes.
As I mentioned in the last issue on convertible instruments, these structures have become more and more relevant for investors and founders over the past decade. They have helped provide a temporary solution for aligning incentives, especially when it comes to valuation.
For today, we are going to answer…
What are they?
How do they work?
Why should you use them?
What are convertible notes?
Convertible notes are one of the more common investment instruments in venture capital.
Convertible notes (aka, convertible promissory notes) are short-term debt instruments that convert to equity upon a predetermined conversion event or date.
Venture investors will offer startups convertible notes in exchange for the ability to convert into equity at a later event or date, such as at a qualified financing round, maturity date, or liquidation event. The notes will convert from short-term debt into equity (typically preferred shares) at this defined event or point in time.
To be clear, convertible notes are considered debt on a startup’s balance sheet up until the point of conversion. This means that they operate and behave like debt instruments, which includes seniority to the equity holders, earning interest, and an eventual maturity date.
Ultimately, the purpose of the convertible note is to provide a temporary solution for investors and founders to align on the valuation of a startup.
How do they work?
Convertible notes operate in two states: (1) before conversion, and (2) at the time of conversion.
Let’s walk through how they work in each state…
Before Conversion
Up until the defined conversion event or maturity date, convertible notes operate like traditional debt instruments. They have an interest rate and an eventual maturity.
In most cases, the accrued interest is included in the total value of the convertible notes that convert into equity (as opposed to being turned into a cash payment like traditional debt).
As an example, if you have a $1M convertible note that has been outstanding for a year with a 6% interest rate, the note will have accrued an additional $60,000. This will increase the amount converting into equity from $1.00M to $1.06M, resulting in more shares for the investor.
At Conversion
On the other hand, we have the point of conversion.
There are three events where an investor can convert to equity: (1) qualified financing, (2) maturity date, and (3) liquidation date. Each of these have different mechanisms that guide how the note converts into equity.
Let’s look at each of them in more detail…
Qualified Financing
For a Qualified Financing, the price at which the convertible note converts will be determined by two things…
Valuation Cap – the maximum amount at which a convertible note will convert
Discount Rate – discount rate to the valuation of the future priced round
Convertible notes will usually contain at least one of these two terms, if not both, within their structure. In the case where there is both a valuation cap and discount rate, the note will convert at the lower price of the two options (the more favorable outcome for investors).
For example, let’s say we have a $5M post-money valuation cap and a 20% discount rate. The startup is raising a $2M round at a $8M pre-money valuation. With the 20% discount, this comes out to a $6M pre-money valuation, which is higher than the post-money valuation cap of $5M.
In this scenario, you would use the $5M post-money valuation to price the conversion, which is more favorable for the convertible note holder.
Note: Make sure you’re thinking through the differences between pre-money valuation and post-money valuation. This is important when deciding which price will be lower.
Liquidation Event
In a liquidation event, investors will typically have two options:
(1) Receive a liquidation preference that pays the investors anywhere from 1-3x the original amount of the convertible note. This protects investors capital and, depending on the multiple, can provide a small return for providing the capital upfront.
(2) Convert the note into common shares at a price determined by the valuation cap and then sell those shares in the transaction. This is done in the “upside scenario” where the company is sold for more than the valuation cap and the amount that the investor would receive via the liquidation preference.
Maturity Date
OK, so what happens if there is no qualified financing or liquidation event?
We then run into the maturity date.
In theory, the convertible notes would either be paid pack to the investors (plus any accrued interest) or convert into equity (if defined in the agreement). However, in practice, the maturity date usually forces a conversation between the investors and the startup about how to proceed.
In this situation, the convertible note holders have three options…
Force repayment
Extend the maturity date
Negotiate a conversion
Investors rarely force a repayment. In most cases, this is hard for a startup to do (i.e., they don’t have much cash) and it’s not the outcome that the investor was targeting (i.e., a venture-type return). If the startup is still a going concern and has a chance, there is usually something that can be worked out between the two parties. If not, it may be about guiding the startup to a liquidation event.
Most of the time, the investors and startup will agree to extend the maturity date to give the company more time to raise a qualified financing. Although, this extension may come with some renegotiating of the conversion terms in favor of investors.
Another common option is to convert into equity. The startup may no longer need additional financing due to a combination of the note and their performance. In this case, the investor will likely negotiate a conversion of the note (if not specified in the convertible note documents).
Why should you use convertible notes?
The main reason for using a convertible note is investors and startups can’t agree on a set valuation. This will temporarily align incentives and push the valuation decision to a later point.
But, there are other reasons. Let’s look at some of the other reasoning behind using convertible notes for startups and investors.
Startups
Startups like to leverage convertible notes for a few reasons…
Fast & simple – convertible notes are much easier to negotiate than priced rounds due to their simplicity
Lower costs – the reduced complexity also means they are cheaper than structuring a priced round
Quick & flexible fundraising – startups can raise capital much more quickly on convertible notes (due to the lower complexity) and raise over a rolling time period (a startup may raise capital on a convertible note from several investors over a few months)
Retain control – since this is a debt instrument instrument until conversion, the founders or executives retain the same level of control over the startup
Investors
Meanwhile, investors have their own reasons for using convertible notes…
Saves time & money – this structure is simpler and costs less than a price round
Senior & liquidation preference – compared to other convertible instruments, convertible notes have better liquidation preferences (in addition to being senior to shareholders as long as it remains debt)
Favorable conversion terms – as compensation for providing capital in advance of receiving equity, investors will often receive favorable conversion terms (vs. a future price round)
Interest rates – the interest rate can be converted into future equity
As you can see, there are benefits on both sides for using convertible notes, especially when there isn’t an agreement on valuation.
Next issue, we’re going to dive into SAFEs before discussing the different situations in which investors use these two instruments.
