A Note on Notes: Hidden Costs of Convertible Notes

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It’s been really exciting to watch the explosion of startup activity the last three years. This expansion has been characterized by technology infrastructure shifting from fixed cost to variable, proliferation of seed funds and accelerator programs, exit markets opening and other factors.

A byproduct of this increase in seed investment activity is the wide use of convertible notes. I am all for structural innovation, but I believe that the use of convertible notes has drifted away from the original purpose, and this shift is a bad thing for founder and investor alike.

Convertible notes used to be called bridge notes, and they usually served a specific purpose to finance a company for a limited period of time (3-6 months) to complete a financing under termsheet, or achieve a major milestone so that the next round would be easier to raise and/or at a materially higher valuation. These notes were often done by insiders and did not have a capped valuation, for fear of signaling to a new investor what the valuation of the company might be. This was especially true because the period of time before that subsequent financing was pretty short. Notes came with a 20% discount, and because the maturities and time outstanding was usually short, this juiced the return on the notes to compensate investors for the risk of a subsequent financing not occurring.

Convertible notes evolved and became a prevalent way to finance a seed stage company. These notes were larger amounts than bridges, and also featured longer maturities, with a subsequent financing being more unknown. I think there were three primary drivers for this: (1) the founder and investor did not have to negotiate a valuation, particularly at such an early stage when the company’s valuation is the most subjective and difficult to determine and (2) it was much less expensive legally to implement a note financing and (3) this method almost always is better for a founder, since a 20% discount to a future yet-to-be-determined price is unlikely to compensate an investor for the risk. The 20% is fixed, and if a note is outstanding for a year or more, the 20% doesn’t scale and the price of the next round is likely to be higher. Consider a bridge over 3 months that gets a 20% discount, which is equivalent to 80% annual return (not including interest). A convertible note round that lasts 18 months is more like a 13.3% annualized return. Yes, a company that has more capital is less risky, but it’s less risky to lend to a company that has a relatively certain approaching financing event, why should that get a higher return? Interest does scale naturally, but the low rates means it is not the way to compensate for risk.

There are other more minor factors that work in favor of the founder, including that investors do not have shareholder rights and typically do not join boards of directors as note holders.

One of the elegant things about venture finance is that in a typical equity financing, incentives are generally aligned between founder and investor. I say generally, because liquidation preferences allocate proceeds at “low” sales disproportionately, but for most decent outcomes, investor and founder incentives tend to converge.

But in a convertible note financing, incentives are opposed. Founder has a strong incentive for the next round to be at a very high valuation. There is a double benefit here: new capital will be less dilutive and the early note capital that will convert will also be less dilutive. It’s like bowling a frame after a strike. You know that this frame has a multiplier effect on the prior frame in addition to the current frame. But the note investor is in an awkward position. Every investor wants his/her companies to succeed. But as the company makes more progress, slaying risks and propping up potential rewards, the investor sees the price they are paying increase. The reward for taking an early risk on the company is a retroactive price increase. So if you reduce everything down to the carnal essence of financial incentives, the investor wants the company to do well enough to attract a financing, but not so well to have a large run up in price. So consider an investor, sitting at his/her desk with a great introduction to make to the company that they know could cause them to pay a much higher price on funds invested a year ago or longer. A good investor still makes that introduction, but at the essence it’s perverse.

This disconnect is largely due to an investor taking a specific risk at a specific time for an unspecific price. A price that the investor can influence. I can’t think of other markets where this occurs.

About three years ago, the concept of a conversion cap emerged. It’s a maximum share price at which the note would convert. This addressed the issue of a valuation run-up. Investors were protected by virtue of this cap, and that alleviates some of the misaligned incentives, but not entirely.

When a company raises capital at a price higher than the note, investors rejoice, but it doesn’t mean they were compensated for the risk they took. Furthermore, it requires that a cap is negotiated, which defeats one of the primary benefits of a note in the first place. The cap becomes a signaling mechanism and in some cases may limit the eventual valuation placed on the company.  Then notes got structured to capture upside, with provisions that multiplied the payoff if the company was sold before the note converted to equity. It’s more often now that I see absurd over-engineered notes that essentially are priced equity.

It is true that the use of notes has resulted in financings occurring that otherwise wouldn’t have. It might seem like a good thing for founders, but when incentives aren’t aligned with investors, and when investors aren’t compensated for the risk they take, it can harm the ultimate outcome of the company. Plus, maybe some of these companies shouldn’t be funded in the first order.

This theoretical argument may not be enough to compel founders to choose equity over notes to seed their companies, or investors to invest in seed deals to buy “access” even at inflated prices. As the terms have evolved though, founders choosing the note path are really issuing synthetic equity, so maybe we should all go back to doing true equity in the first place.

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  • campbellmacdonald

    Jason: Good points which I largley agree with. Other than simpler docs, I see the main benefit of raising on a note to be the rolling close. If there were a simple mechanism for a rolling close on a priced round, it may become more attractive for angel and seed rounds. (If that mechanism exists, please let me know).

    • jheltzer

      Yes, good point. I think investors are okay with multiple closes so long as they occur in a short period of time, perhaps a month or two. The tricky part of extending it further is pricing. As I mentioned in the comment above, if you adjusted the pricing up as time goes on (presuming the company is progressing) then it could work, at least theoretically. The one complication that I think is an obstacle is that with disparate prices, you might need to create separate classes of stock. That’s expensive and complicated, and since it’s unusual, it might deter future investors. An alternative is to keep the price of the stock the same and issue warrants to earlier investors and reduce the number of shares for which the warrants can be exercised in the future as the closes occur. That probably would be simpler and would achieve the same result. thanks for your comment.

      • campbellmacdonald

        These mechanisms all work, I get it. I think they are all more complicated than notes. So while equity is likely better for alignment in the long run for all parties, given the nature of resources in the seed stage: Simple, Fast >> Better but complicated.

  • rh

    Unscrupulous founders have used convertible notes without a cap and a rolling close to avoid raising a structured round of capital to trigger conversion. Having faced one founder who has used the note structure to avoid triggering the conversion one has very limited options and choices to participate in the relative upside.

    In this instance he is trying to drive up valuation to the maximum because there is no cap. Lesson learnt from this episode is never to invest in a convertible note without cap as also to set hard date deadlines for conversions.

    Should the founder not agree it ain’t worth investing because then the underlying assessment is that he is selfish and only interested in his himself and his upside not the investors.

    • jheltzer

      I don’t know if you would call them unscrupulous. It may be that (a) the supply/demand of capital at this moment in time favors the entrepreneur or (b) they have a great company and they are able to demand that structure and rolling close. I don’t have an issue with a rolling close so long as the pricing is adjusted (or in the case of the notes, the discount) so that those that took a bigger risk get compensated more or have structural priority.

      The only circumstance where I think an uncapped note is prudent is the situation I outlined in the post where you are already an equity investor. Other than that, I think you are right about the rule you propose.

  • Jason, great thoughts in the post, although I think they heavily favor investors over founders. You listed three reasons, but I don’t think #1 (pricing the round) and #3 (not compensating the investor risk) are as much part of the equation. Many notes are capped, which from an investor’s stand point, they should be. This eliminates the argument that the round isn’t priced and it does provide more upside than just a 20% discount on a note.

    As an entrepreneur, point #2, the simplicity and cost would be the biggest factors for me. An equity round could easily cost an additional $20-$50k beyond a note. For a startup where the biggest constraints are usually resources, that could be half of annual salary for an additional headcount. So in my mind, would I rather bring on additional resources for the company or would I rather give tens of thousands extra to lawyers… that’s an easy decision – I would rather issue “synthetic equity” than true equity if it could positively impact the company.

    Now if I were raising a multi-million dollar round, yea, it makes sense to do a priced equity round. But even at a $1M round, capped notes could make sense. Sure, investors won’t have shareholder rights, but in future financing rounds early investors’ shareholder rights may be decimated anyway unless they participate pro rata.

    And lastly, something I never hear brought up, although I’m not sure how common it is – as a note holder, you have more downside protection than as a shareholder. If the startup goes under and doesn’t raise a future round you’d rather be a debt holder than an equity holder if there are any IP or other assets that could be liquidated.

    • jheltzer

      all good points. Caps are often set at pretty inflated values, so I don’t know that it really protects an investor or compensates an investor for the risk they take. Cost is an amplified factor in rounds sub $1M, Form equity documents have reduced the cost of an equity round, but not as much as I would have thought. And I agree, cash going to lawyers is not where an investor wants money going either.

      You are right that a debt holder has senior claim when there is a liquidation. That matters a lot more when there is equity underneath you, because if you do a preferred equity round as the seed round, you are still senior in the liquidation. Instead of taking possession of the IP, the company sells the IP and proceeds are distributed to the preferred holders. Yes, you can’t foreclose on the company like a creditor could (something investors rarely do anyway), but the economics wind up being the same.

      But fair points.

  • Jason –
    Great post. I disagree with @disqus_2V60l525Ug:disqus here. I hate doing convertibles as an investor because you – by definition) do not get the upside in on your money from the time of your investment. You get upside from some unspecified future date. Yes it may be capped as they often are – but even the capped valuation (less your discount) is worth realistically 2-3x the investment value. And the seed market is so mature now – with active seed investors and funds in every market – that it is relatively easy to price a seed round. Additionally, if you use the Series Seed docs you can get a deal closed for way less than @20K. I also think it aligns incentives going forward because the (smart) entrepreneurs realize that they have to stair step up a valuation and it’s not all about optimizing for the “next” round. To your very well put analogy on bowling – this really makes an entrepreneur want to max out that first Series A round. Finally, you the downround protection is virtually the same. And I am an entrepreneur in addition to being an investor – I have lived both sides. My advice is do a seed deal as real convertible preferred, at a reasonable valuation and option pool and BOD.

    • jheltzer

      well said Alan.

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