The Conundrum of Convertible Notes
This week, for the first time since I began this series, I
am going to express an opinion with which I know many of you, both first-time
entrepreneurs and investors, are going to disagree.
Except in very special circumstances, I do not
like convertible notes as an investment vehicle.
YouÕve started your company and have done a great job of
bootstrapping it so far. YouÕve
been able to convince some friends and business associates to join you, or to
work nights and weekends, so that your product is really beginning to take
shape. You know that it will just
take a little bit more effort to do those things that will attract an investment
from a venture capitalist.
BUT, you need just a modest amount of money to make it from
here to there [hence, the term, Òbridge loanÓ].
You get linked up with some angel investors and they get
excited about you, your company, and its investment return potential. At that
point the conversation usually goes something like this.
You: ÒYour modest investment will help me get to the point
where venture capitalists will want to invest and then itÕs all downhill from
there.Ó
Angel: ÒYouÕve convinced me. What did you have in mind?Ó
You: ÒWe need to put together a convertible note with a
premium for you for coming in now. ThatÕs what all the companies at this stage
do.Ó
Angel: ÒIÕm not sure I get it. Please explain.Ó
You: ÒOnce we have done the things that your money will enable us to do
[gotten a customer, completed an alpha or beta test, attracted someone to the
management team], the VC is going to want to invest. Since we canÕt really value the company today, weÕll let the
professional investor establish the value when he invests. In exchange for you coming in now,
though, I will offer you a sweetener so that you will buy your stock in that
round at a discount to the price the VC pays.
ÒBy making it a note, if something were to go wrong, but
nothing will, but if something did, your note will be higher in the pecking
order for repayment than stock.
ÒBesides, if we tried to value the company today, the VC
would probably use that value against us when we negotiate his round. IÕm just
looking out for you so that youÕre treated fairly.Ó
Angel: ÒGee, thanks.
Who do I make the check out to? What do I need to sign?Ó
As IÕve done before in this series, IÕve taken some poetic
license, but itÕs not too far from the truth. The logic appears to make sense.
In many cases, both sides think that theyÕve done the right thing and that itÕs
onward and upward.
A convertible note is a loan to the company, with an
interest rate, that the investor has the right to convert the entire principal
amount of the note (and often any accrued interest) into equity when an
institutional investor subsequently makes an investment. Usually there is a premium for
investing at this time. More
specifically:
This is the amount that the company is ÒborrowingÓ from the
investors. In most circumstances, each investor will an identical note with
only the names of the note holder and the amount of the note being
different. For example, a round of
$100,000 might be shared by five investors investing $40,000, $25,000, $15,000,
$10,000 and $10,000, respectively.
Sometimes, a limited partnership, or its equivalent is formed; the
investors invest in that; and then the LP becomes a single investor in the
company.
In my recent experience, annual interest rates on these
loans are usually in the 6% - 10% range.
In exchange for investing now, the investor is given
additional consideration that effectively lowers his price per share as
compared to the price paid by the subsequent investor. Often a specified
discount in the range of 15-40% is used depending upon lots of
circumstances. This number may be
fixed or may increase over time. An alternative would be to issue warrants
based upon an agreed to formula.
The convertible note is done with the presumption that it
will, in fact, be converted. If it isnÕt, then the method of repayment must be
defined.
Further, your private investor is doing this deal for the
thrill of potentially making a lot of money. As such there will be
restrictions, or prohibitions, related to prepayment.
The interest may be treated in several ways. You may want to have the interest
accrue so that it doesnÕt impact your cash flow. That may be agreeable to the investor if the accrued
interest will convert with the principal. Alternatively, you may want to pay
the interest quarterly to avoid the additional dilution that would occur with
it accruing and converting. Having current income from the investment may be
desirable to your investors as well.
You have solicited this investment with the explanation that
it will enable you to attract a significant investment on favorable terms. The
investor will want to define what that means. Not that you would, but the
investor doesnÕt want your Uncle Charley to invest $1,000 at $10 per share, and
have that cause his loan to be converted as well. Usually, there needs to be at least a minimum amount raised
before the conversion would occur.
As in any such security transaction [and a loan of this type
is a security and must comply with the relevant securities laws], the investors
will have certain protective provisions.
Usually, certain transactions will require a majority approval of the
note holders for such things as taking out loans above a certain amount,
selling some or all of the important assets of the company, creating a new
security that is senior to theirs, and the like.
This is the date upon which your investor can seek repayment
of the note. Depending upon
circumstances, this might be as short as 30 days or could stretch over several
years.
If your investor requests to be repaid per the terms of the
agreement, and the company is unable, or unwilling, to make that payment, then
your investor will have certain rights that he can invoke through the judicial
system.
While this may all sound reasonable, the consequences may
not be.
Nine times out of ten (actually more), a first-time entrepreneur
will not achieve the operating objectives on a timely basis.
The consequence of this is more money will be needed, and
guess who is the only likely source of that money? Look in the mirror.
Even if the operating objectives are achieved, thereÕs no
guarantee that an investor will be ready and willing to invest.
The consequence of this is more money will be needed, and guess who is the only likely source of that money? Look in the mirror.
Even if you hit your operating objectives and attract an
investor to the bargaining table, thereÕs no guarantee that he will abide by
the terms of your notes. If you only have one investor at the table, and youÕre
running out of cash [which are both highly likely if you get this far], the
Golden Rule will prevail: He who has the gold rules.
If a new investor agrees to invest only on the condition
that the convertible note holders waive some, or all, of their rights, your
original investors are between a rock and a hard place. They are faced with the decision of
giving up all those financial benefits that you had promised them, coming up
with additional money themselves, or let the company crater. Remember, a legal
agreement is only the default if parties canÕt negotiate an alternative
agreement. In this example, the potential investor can choose not to accept the
default, and just walk from the deal.
The premise that not valuing a round today will induce a
higher value later is based upon a flawed premise. An institutional investor will establish what he believes to
be the companyÕs value at the time of the investment consideration. Valuations
of prior rounds, if any, may serve as points of reference, but will not be
major determinants of the companyÕs current valuation.
This is particularly true in todayÕs funding environment and
applies to all new rounds, not just those funded by angels.
If it gets to the point where the maturity date of the note
comes and goes, itÕs highly unlikely that will be because the company is so
prosperous. More than likely, you have not been able to raise the follow on
round of investment. As a result, itÕs highly unlikely that you will be able to
repay the notes when requested to do so. Further, the default provisions and
remedies wonÕt yield much. YouÕve
heard the saying, ÒYou canÕt get blood from a stoneÓ? Well, you canÕt get cash
out of a close-to-bankrupt company.
Quite often, a first-time entrepreneur pitches the
convertible note structure so long and so hard, that he begins to believe that
the follow on investment by the institutional investor is inevitable. After all, the convertible note is a
ÒbridgeÓ from here to there. That mind set can be very dangerous. The
discipline of controlling cash flow can get lax.
Another unintended consequence of this structure is that the
institutional investors will have a disincentive to come to the bargaining
table. Even if you do everything that you say you will do, you are still going
to be an early stage company with lots of risks. The seasoned investor knows
that when a first-time entrepreneur raises angel money, it is highly likely
that the angels will pony up more money if there are no other alternatives. The
investor knows that if he sits on the sidelines, you will further reduce risk
with someone elseÕs money and that the Golden Rule is still likely to be in
effect when he comes to the table.
I opened by saying that I didnÕt like convertible notes
except in specific circumstances.
Since IÕve slammed them so hard, I owe it to you to give you my opinion
as to when they are appropriate.
I believe that they are absolutely the right vehicle for
economic development organizations such as InnovationWorks, Idea Foundry, the
Pittsburgh Digital Greenhouse, and the Pittsburgh Life Sciences Greenhouse. If their early funding launches a great
success, then by all means, they deserve to participate on the upside.
I know for a fact that if current policies had been employed
by InnovationWorksÕ predecessor organization when Sean McDonald launched
Automated Healthcare, the return on its investment would have been staggering
on a relative basis, and awfully darn good on an absolute basis.
I also believe that convertible notes are appropriate
investment vehicles for companies that have already raised money at a fixed
price and all of the current investors are willing to take their pro rate share
of the round.
Frank Demmler is Associate Teaching
Professor of Entrepreneurship at the Donald H. Jones Center for
Entrepreneurship at the Tepper School of Business at Carnegie Mellon
University. (Website)
Previously he was president & CEO of the Future Fund, general partner of the
Pittsburgh Seed Fund, co-founder & investment advisor to the Western
Pennsylvania Adventure Capital Fund, as well as vice president, venture
development, for The Enterprise Corporation of Pittsburgh.