Convertibles: Great cars, bad vehicles

By John Frankel , written on February 8, 2013

From The News Desk

From an investor’s point of view, convertible notes (or "converts" or "convertibles"), while popular in California, rarely make sense except to bridge to an existing investment at an inflection point into a much larger round. This is more than some East Coast/West Coast difference in approach, and  worth taking the time to dig into it.

Advantages of convertible notes

Convertible notes are simple, and the legal costs are less. Nivi of Venture Hacks observes that debt term sheets are typically one to two pages long and the closing documents are usually less than 10 pages, vs. the typical preferred-equity term sheet (a few pages), which translates into 100 to 200 pages of closing documents. Converts have historically been faster and cheaper. As more early-stage investors use templates such as the NVCA model venture capital financing documents, however, this advantage has largely faded. Likewise with startup lawyers willing to work on a capped-fee basis, the related cost advantage is significantly reduced. The 100- to 200-page difference is not just ink, but specificity, which is lacking in converts.

In subsequent investments, convertible debt can make sense. In the debate over early-stage convertible notes, their true origins as a bridge-financing instrument too often get relegated to a footnote. Converts started out with a specific purpose in mind: to provide short-term funding for a startup to achieve specific milestones that would improve its leverage (i.e. increase its valuation) in an imminent round of venture funding.  It was a stop-gap or a bridge to the financing.

Here the primary benefits of convertible notes (speed and relative savings) do actually come into play. For example, if your startup will start looking for Series B funding in 90 to 120 days, and needs a capital infusion to make key hires, see product gain traction, etc. then raising short-term capital via equity would likely take way too much time and energy to fulfill that purpose. Raising a convertible note with an existing investor is more efficient and better aligns incentives (though not perfectly).

They also allow existing investors to size-up their investment before the detailed negotiations of the next round where their voice might not be heard as the terms and participants are agreed between the board and the new investors. We have made a number of convertible investments at exactly this stage in the company’s development, and it has generally worked out well for all parties.

Disadvantages of convertible notes

If capped, and they generally are, then it is a cap and not a valuation. If the execution is not what is expected then the discount comes into play and it can be highly dilutive to the founders. Furthermore, if the note is capped and the amount of the note is material to the next round then the terms might be changed ex-post by the investors in the next round so that they get the percentage of the company they "require." This is unfair to the note holders, as the company feels compelled to revisit the terms agreed with them. This is why the discount is sometimes given as warrants as opposed to a percentage discount to the next round, as it is tougher for granted warrants to be revoked vs. changing the percentage discount actually given. Either way it can impede negotiations for the next round.

Now, if the note is uncapped it can be exceedingly cheap capital, especially if the next round is at a significantly higher valuation. The company should try and do this, but it is certainly not in the interests of the investor to fund the upside and yet not share in it. The misalignment of interests between existing investors and note holders is quite extreme and can lead to unfair outcomes. Given that the investor/founder relationship is long-term and should be strong in good and bad times, just like a marriage, the unfairness can lead to strains in the relationship and investors that are less willing to be helpful.

Often we have found that the many note provisions are vague, creating uncertainty in the case of a default, a smaller raise, etc. As a note holder you effectively do not know what investment you are actually making until conversion and the lack of definition and incomplete or vague provisions simply do not help.

Never forget that notes are debt and debt investors expect to get their principal back. Debt-holders often push for security for their investment, which can lead to difficulty in arranging subsequent traditional bank debt or even unsecured trade debt. Thus the entrepreneur and existing shareholders run a risk that the secured note holders take over the company if there is not a financing, or at least will have placed themselves in an otherwise unfair bargaining position. Again, misaligned interests.

Priced rounds start the clock for Qualifying Small Business Stock Exemption, which can lead to capital gains tax rates at a Federal level of 0 percent, a tax rate most investors like.  Thus priced equity is more valuable to the investor and, other things being equal, willing to pay a higher price for it. Thus there are risks to both the investors and to the existing shareholders if a wrongly structured note is used.

Bill Burnham describes the investor risks here, when he writes that the early investors are essentially "paying for their own participation. They are getting all of the downside and none of the upside between the Seed and Series A."

And let’s not forget, you're leaving all the terms you consider reasonable up for discussion.  Do you really think that a ten-page document is going to be sufficient to describe the relationship of the investors to the company in sufficient detail?

As Chris Dixon illustrated in his post on convertibles, converts give the investor a chance to make money on a successful risk, but they give zero control rights. Investors who attempt to assert more than nominal control run the risk of a lenders liability claim in the event that things go poorly for the company. For a first-time entrepreneur, retaining full control while still getting funded seems like a great deal, but it's also a dangerous approach to developing your investor relationships. The lack of a board for guidance is also a disadvantage.

There are certainly deal terms that are anti-entrepreneur except in extraordinary circumstances, such as excessive liquidation preferences or overzealous forced-sale/no-sale provisions. But there are also reasonable protective provisions that seek to actually protect the investor and the founders and are key steps to building trust early on in a multi-year relationship. Sure, you can give pseudo-control rights by attaching a proposed term sheet to the note that goes into effect upon conversion to equity, but if you've already come to that bridge in the negotiation, you might as well cross it and go for a priced round.

Furthermore, a priced round is the honest instrument to align incentives. In the new age of transparency among VCs, via blogging, social media,, etc., a new trend has emerged towards "entrepreneur-friendly" financings – deals that give investors few, if any, protection rights and are in part the result of frothy markets and VCs making reputational plays. "Entrepreneur-friendly" does not necessarily translate into "startup-healthy," however, if it results in a misalignment of incentives between the entrepreneur and his/her investors.

For example, Daniel Odio, an entrepreneur who raised $1 million in the form of a convertible note, was almost unable to get an essential line of credit from a bank because the new debt would have been senior to the note in his business's capital structure (meaning that the bank would get paid back first, plus interest, before anyone else) and, even for the most benevolent investor, that would have been a no-go. If the $1 million had been raised via an equity financing, the investors would have been fully aligned with Daniel, as full-fledged stakeholders in the business, and therefore supportive of an action that would ultimately increase the startup's chance of success.

In terms of leveraging value-added investors as part of successful early-stage financing, an entrepreneur could find that convertible notes misalign the incentives for investors to contribute or invest their time/effort into helping the business grow. Because the conversion price of the note will be based on the subsequent financing event, note-holders actually have a financial incentive to minimize the valuation at the next round, while the entrepreneur has every incentive to get that valuation as high as possible. Josh Kopelman of First Round Capital expresses this much better in his post on Bridge Loans vs. Preferred Equity.

The bottom line here is that we can hope for the best from investors and trust that they'll take the opportunity to add value wherever they can, but unless you give them a chance to put their skin in the game, there's no guarantee that they'll do so.

So you see, convertible notes do have a role, albeit limited, as a bridging loan, but if you feel you should use them for anything else, lie down until the feeling passes.

[Image courtesy minddesk]