The Conundrum of Convertible Notes

By Frank Demmler

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.

Rationale for a convertible Note

You’ve started your company and have done a great job of bootstrapping it so far.  You’ve 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, “bridge loan”].

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: “Your modest investment will help me get to the point where venture capitalists will want to invest and then it’s all downhill from there.”

Angel: “You’ve convinced me. What did you have in mind?”

You: “We need to put together a convertible note with a premium for you for coming in now. That’s what all the companies at this stage do.”

Angel: “I’m not sure I get it.  Please explain.”

You: “Once 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 can’t really value the company today, we’ll 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.

“By 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.

“Besides, if we tried to value the company today, the VC would probably use that value against us when we negotiate his round. I’m just looking out for you so that you’re treated fairly.”

Angel: “Gee, thanks.  Who do I make the check out to? What do I need to sign?”

As I’ve done before in this series, I’ve taken some poetic license, but it’s not too far from the truth. The logic appears to make sense. In many cases, both sides think that they’ve done the right thing and that it’s onward and upward.

Standard features of a convertIble note

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:

Principal Amount

This is the amount that the company is “borrowing” 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.

Interest Rate

In my recent experience, annual interest rates on these loans are usually in the 6% - 10% range.

Risk Premium

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.

Repayment Terms

The convertible note is done with the presumption that it will, in fact, be converted. If it isn’t, 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 doesn’t 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.

Qualifying Transaction

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 doesn’t 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.

Protective Provisions

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.

Maturity Date

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.

Default & Remedies

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.

Potential flaws of a convertible note

While this may all sound reasonable, the consequences may not be.

Operating objectives won’t be met on time

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.

Achieving operating objectives doesn’t attract investment

Even if the operating objectives are achieved, there’s 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.

Institutional investors may not honor the terms of the note

Even if you hit your operating objectives and attract an investor to the bargaining table, there’s no guarantee that he will abide by the terms of your notes. If you only have one investor at the table, and you’re 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 can’t negotiate an alternative agreement. In this example, the potential investor can choose not to accept the default, and just walk from the deal.

Institutional investors will probably ignore your valuation as a frame of reference

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 company’s 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 company’s current valuation.

This is particularly true in today’s funding environment and applies to all new rounds, not just those funded by angels.

The downside protections aren’t really fair

If it gets to the point where the maturity date of the note comes and goes, it’s 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, it’s highly unlikely that you will be able to repay the notes when requested to do so. Further, the default provisions and remedies won’t yield much.  You’ve heard the saying, “You can’t get blood from a stone”? Well, you can’t get cash out of a close-to-bankrupt company.

Counterintuitive investment incentives

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 “bridge” 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 else’s money and that the Golden Rule is still likely to be in effect when he comes to the table.

Appropriate Use of Convertible Notes

I opened by saying that I didn’t like convertible notes except in specific circumstances.  Since I’ve 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 InnovationWorks’ 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.

Advice to entrepreneurs

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.