Fads come and go and some need to go. Convertible notes are one such fad. The idea sounds great to a startup. All you have to is issue debt to investors and if you cannot pay it back at maturity your debt converts into equity. You do not have to make any payments until maturity. How bad could it be? The note is only a few pages long. Start-ups are told it is a quick and cheap way to raise money. That is certainly true for the investor.

Danger ahead

I have several issues with this financing mechanism:

1. The premise of a company with no cash flow or net profits servicing a debt instrument is magical thinking
2. Founders are rarely aware of the complexity and nuances of the conversion process
3. Failure of the founders to actively negotiate and evaluate the conversion details can lead to founders losing their shirts

Debt for a start-up?

Why enter into an agreement that you know is problematic at the outset? As a founder you are not interested in making monthly debt payments to a seed investor. You are most interested in putting that money to work on your product or service or hiring staff. As an investor do you really want to deal with the regulations relating to loaning funds and potential tax impacts?

Conversion 101

Here are some of the topics that need to be resolved for the convertible note to work:

1. How will the conversion to equity be calculated?
2. Will the seed investors receive common stock or preferred stock?
3. What about dividend rights?
4. What type of liquidation preference will be given to investors (straight, participating, or capped)?
5. Will there be a liquidation multiple (e.g. 2x)?
6. How will the principal and interest payments be treated in the conversion?
None of these are unsurmountable but they require careful analysis and sophistication to understand the risks and rewards.

Conversion complexity and liquidity preferences

To make matters worse additional issues come up in case of time gaps between the seed debt and Series A. Issues to consider here include:

1. If the valuation increases significantly from a seed round to Series A, how will this impact the mechanics of the debt to equity conversion?
2. Are the conversion formulas the same for an acquisition event v. a Series A investment?
3. Will the seed investors received Series A preferred in the follow-on financing on the same terms as the Series A investors?

Liquidity overhang

Liquidity overhang is a situation where an investor receives a return of capital upon note conversion that is different than the amount of the original investment (often several times more). The problem is that this can happen automatically and without any negotiation if the founders are not careful. As Mark Suster recently pointed out in vivid detail on his blog, bothsidesofthetable.com, the issue of a liquidation overhang is a surprise to and pitfall for many first time entrepreneurs. As the size of the investment increases and the follow-on valuation increases the importance of the overhang increases. Without protections in place founders will be giving away potentially millions to seed investors for no other reason than nobody advised them against it.

Better options

Founders and investors would be better served using Y Combinator’s SAFE (simple agreement for future equity) or structuring a more complicated capital structure with the investor. The SAFE is attractive because it requires little attorney time and back and forth negotiation. A more complicated capital structure could include creating a junior preferred stock, or classes of common shares.

Takeaway

If your investor insists on a convertible note, do the following:

1. Retain a startup lawyer
2. Educate yourself on the economics of these transactions
3. Model different scenarios using variables referenced in the document

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