Startups need substantial capital to launch and grow. They need money to develop core products or services, build operational capacity, and fund day-to-day operations. Because few entrepreneurs have sufficient resources to self-finance their startups through profitability, they must turn to outside investors to get through the unprofitable years. Venture capital firms, angels, and accelerators have developed as some of the most important outside investors for startups. They usually invest by purchasing a startup’s stock (most often preferred stock). However, they sometimes buy other types financial instruments. Convertible notes are one of these other financial instruments and they have increasingly become the financial instrument of choice for early-stage startup investments.
Convertible notes allow early-stage startups to raise a modest amount of capital before pursuing their first preferred stock financing. This post explains how convertible notes work and provides some insights on their advantages and disadvantages.
How do Convertible Notes Work?
Convertible notes are short-term loans that automatically convert to equity if a qualified future financing round closes. Convertible notes are debt instruments, meaning the startup must repay the principal and pay interest. However, unlike traditional debt instruments, convertible note investors are not looking to be repaid with cash. Instead, they hope to be repaid with shares from a high-quality future stock offering.
The best way to explain convertible notes is with a simplified example.
Example: Tech Co. issued convertible notes to a group of angels. Here are the key terms:
- Principal amount: $500,000.
- Maturity: The notes mature in 18 months (the “Maturity Date”) unless repaid or converted earlier.
- Interest rate: The notes carry an interest rate of 5 percent per year. Unpaid interest is added to the principal.
- Automatic conversion: If, prior to the Maturity Date, Tech Co. consummates a preferred stock financing of at least $5 million (a “Qualified Offering”), then the principal plus unpaid interest will automatically convert into shares of the preferred stock.
- Sale of the company: If Tech Co. is acquired prior to the Maturity Date or automatic conversion, note holders will receive cash equal to the outstanding principal plus unpaid interest.
- Loan reaches maturity: If the notes are not converted by the Maturity Date, note holders may elect to either (a) receive cash equal to the outstanding principal plus unpaid interest or (b) convert the outstanding balance into Tech Co.’s most senior class of stock at a price per share of $2.
Let us add some detail to the above example. Tech Co. needs the money to cover manufacturing costs for its newly-developed product. Without the $500,000, Tech Co. could not produce and sell its product, and would soon have to shut down. Obtaining the money, therefore, is great news for Tech Co. However, the money comes with significant strings attached. Tech Co. must do one of three things in the next 18 months:
- Complete a Qualified Offering;
- Generate enough profits from selling its new product to repay the notes; or
- Sell the company and have the acquirer repay the notes.
Convertible Note Advantages
Convertible note deals can be done quickly. Importantly, they do not require the startup and the investors to value the company. For early-stage startups—some of which may not yet be selling products—determining value can be difficult. Convertible notes allow the parties to let a future funding round, when the startup is more mature, determine value.
Example—Automatic conversion after Qualified Offering: Consider the above example, and assume the following additional facts:
- Qualified Offering: Tech Co. conducted a Qualified Offering after 12 months. Tech Co. raised $7 million in a Series A preferred stock round at a $20 million valuation and a $10 price per share.
- Outstanding principal plus interest: Tech Co. did not make any principal or interest payments, so the outstanding principal plus interest for the notes was $525,000.
Because Tech Co. consummated a Qualified Offering, the $525,000 of notes automatically converts into Series A preferred stock. Note holders will receive 52,500 shares (or $525,000/$10).
Convertible Note Disadvantages
Convertible notes are a temporary, or bridge, financing option. They should only be used when the startup needs a modest amount of immediate funds and can reasonably project to raise a much larger amount of money in a not-too-distant equity offering. If a Qualified Offering (or sale of the company) does not occur before the notes mature, the startup must repay the loan, which can often force it into bankruptcy and possibly dissolution. In addition, because convertible notes are debt, they trigger state lending regulations. Complying with the lending regulations can increase the legal fees for structuring the deals.
Discount Rate and Valuation Cap
The above example left out two of the most hotly negotiated issues in a typical convertible note deal: the discount rate and the valuation cap. Note holders invest before preferred stockholders, so they assume more risk. If the notes convert to preferred stock without any adjustment (as in the above example), they are not compensated for the additional risk. Note holders receive interest from the notes, but the interest rates are usually too low to compensate for the additional risk.
Therefore, note holders usually insist on including a discount rate and a valuation cap in their notes.
- Discount rate. The discount rate is a discount the note holders receive when converting their debt to equity in the Qualified Offering. Actual discounts can be as low as 0 percent or as high as 50 percent.
- Valuation cap. The valuation cap limits the price at which the notes convert into equity.
Startups would prefer to issue convertible notes without a discount rate or a valuation cap. However, investors typically insist on receiving both protections. Usually, the valuation cap or the discount rate applies when converting the notes to equity, but not both. The note holders would convert using whichever method is more favorable for the note holders.
Example—Discount rate and valuation cap: Consider the above example, and assume the following additional facts:
- Discount rate: The notes will convert at a 20 percent discount to the valuation realized in the Qualified Offering.
- Valuation cap: The notes have a valuation cap of $12 million.
Tech Co. conducted a Qualified Offering after 12 months. Tech Co. raised $7 million in a Series A preferred stock round at a $20 million valuation and a $10 price per share. Tech Co. did not make any principal or interest payments, so the outstanding principal plus interest for the notes was $525,000. Because Tech Co. consummated a Qualified Offering, the $525,000 of notes automatically converts into Series A preferred stock.
Discount rate calculation: The conversion formula calls for the notes to convert at a 20 percent discount.
- The $10 price per share must be reduced by the 20 percent discount (20 percent of $10 is $2).
- $10 – $2 = $8
- The note holders’ price per share is $8.
- The note holders will receive 65,625 shares (or $525,000/$8).
Valuation cap calculation: The valuation cap ($12 million) is lower than the actual valuation ($20 million), so the note holders’ price per share must be adjusted.
- Step 1: Divide the valuation cap ($12 million) by the actual valuation ($20 million), which equals 60 percent.
- Step 2: Multiply the preferred stock price per share ($10) by the Step 1 percentage (60%), which results in an adjusted $6 price per share.
- The note holders will receive 87,500 shares (or $525,000/$6).
In this case, the valuation cap calculation is more favorable for the note holders, so the notes would convert using the valuation cap.
Control Rights and Risk Management
Most startups fail. This does not mean startups are bad investments, but it does mean they are risky. Sophisticated startup investors (such as venture capital firms and experienced angels) employ a number of techniques to reduce this risk. One technique is to use highly-tailored preferred stock instruments. When sophisticated startup investors invest, they usually purchase convertible preferred stock. Like other forms of preferred stock, convertible preferred stock is highly customizable. However, startup convertible preferred typically possesses a number of standard features. It resembles common stock, but with additional features (such as designated board seats and special voting rights) designed to protect its investors by ceding them substantial control over the startup.
Convertible notes generally do not provide their holders with extensive control rights. They take a different approach to managing the risk associated with startup investing. Convertible notes are used when the startup can reasonably project conducting a Qualified Offering to sophisticated investors in the not-too-distant future. Rather than directly seek control rights in the startup, convertible note holders piggyback onto to the subsequent, sophisticated investors’ rights. Convertible notes protect their holders by pushing the startup to promptly seek sophisticated investors who will receive control rights. The maturity date establishes a firm date by which the startup must conduct a Qualified Offering, or risk possible bankruptcy, and the notes’ “Qualified Offering” definition (which usually describes the amount and type of offering) ensures the subsequent investors are appropriately sophisticated.
Reaching Maturity before a Qualified Offering or Sale of the Company
As noted earlier, the startup must repay the loan if a Qualified Offering (or sale of the company) does not occur before the notes mature. If the startup does not have funds to repay the notes (which is typical), the note holders can force it into bankruptcy and possibly dissolution. If the startup is lucky, it may be able to negotiate with the note holders to extend the maturity date or amend the terms of the loan. However, the startup should not count on such cooperation when deciding to do a convertible note offering. Rather, entrepreneurs should view a convertible note offering as putting the startup on the clock. The startup must complete a Qualified Offering (or sell the company) before the maturity date or risk being shut down.
If an entrepreneur is not confident in her startup’s ability to complete a Qualified Offering (or sell the company) before the maturity date and she is not willing to bet the company, she should consider alternative financing options such as SAFEs (or Simple Agreement for Future Equity). SAFEs are explained in a later blog post.
Convertible Notes are Securities
Finally, it is important to point out that convertible notes are securities under federal and state law. Therefore, offering and selling convertible notes must comply with federal and state securities laws. Failure to do so presents serious problems for the startup, its officers and directors, and the professionals (including the lawyers) who assisted with the illegal securities sale. For example, investors who bought securities in an illegal securities transaction have rescission rights allowing them to return the securities and get their money back. Fines, penalties, and even criminal prosecution are also a real possibility. Experienced securities lawyers should always be engaged when offering and selling convertible notes.
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Note: This blog post is for informational purposes only. It provides general information about a legal topic, but does not provide any legal advice. You should contact your own attorney for any legal advice. This blog post does not create an attorney-client relationship between the author and any reader.
 George Deeb, Comparing Equity, Debt And Convertibles For Startup Financings, Forbes (Mar. 19, 2014), available at https://www.forbes.com/sites/georgedeeb/2014/03/19/comparing-equity-vs-debt-vs-convertibles-for-startup-financings/#92aed4d69ff9.