This post explores convertible notes. A future post will explore SAFEs.
A convertible note, also known as “convertible debt,” is essentially a loan to a company to allow the company to operate until it can raise a more formal round of financing. When the more formal round of financing occurs, usually in the form of a preferred stock financing, the convertible promissory note is converted into (exchanged for) shares of the preferred stock issued in the financing. Because it is a loan, convertible notes will have an agreed interest rate, but there are no payments due on a convertible note until the earlier of the closing of the preferred stock financing when the note converts, when the company is acquired, or some outside maturity date.
Convertible notes and SAFEs are often called “bridge financings” because they provide a company with a bridge to cross over the river to the pot of gold that is a future financing round.
Basic Features of Convertible Notes
Some basic features of a convertible note include (we will discuss more complex features of valuation discounts and caps later):
- Principal Amount. The principal amount (also called the “face amount”) of the convertible note is the amount the investor loans the company in exchange for the convertible note. There are no periodic repayments of the principal, like monthly or quarterly payments.
- Interest. Because the convertible note is a loan, the note will have an annual interest rate. However, the idea is not to pay out the company’s scarce cash as interest, so this interest accrues and is included with the principal when the note converts. Interest rates are often in the 3% to 5% range.
- No Interim Payments. Because the idea of convertible notes is to provide the company with cash to operate until it can raise a larger financing round, there are no payments of principal or interest until certain events occur, such as the closing of a “qualified financing”, or the sale of the company, or some outside maturity date.
- Mandatory Conversion. The convertible note automatically converts into the shares of stock issued as part of a “qualified financing.” This means that when a qualified financing occurs, the principal amount and all accrued interest are converted into (exchanged for) shares issued in the qualified financing.
- Qualified Financing. A “qualified financing” is usually a preferred stock financing that provides the company with some minimum amount of proceeds. The minimum amount of proceeds is important, because if there is no minimum amount of proceeds, then the company could hold a very small preferred stock financing which would trigger the conversion of all outstanding convertible notes, and then hold a larger financing, which could result in dilution to the convertible note investors. Because of this, convertible note investors will require that the future preferred stock financing be a meaningful amount, often several million dollars.
- Maturity Date. An investor in a convertible note understands that the intent is for the note to convert into the stock issued in the qualified financing. However, if the company is unable to raise the minimum amount required in the qualified financing, then at some future point in time, the note investors want to be able to force the company to repay the note, or renegotiate the terms of the note. That future date is the maturity date. The maturity date is usually between one and three years after the date of issuance, with 18 months a popular time frame. Practically speaking, if a start-up company can’t raise the minimum required in the qualified financing, then the company probably won’t have a lot of value or assets available to repay the notes. The reason for the outside maturity date is to give the convertible note investors negotiating leverage with the company.
- Unsecured Debt Obligations. Convertible notes are unsecured debt obligations of the company. For those new to capital structure, there are four basic levels in a capital structure: secured debt, unsecured debt, preferred stock and common stock. Secured debt is the highest level in the capital structure. Bank loans are the most common type of secured debt. Secured debt means that the loan is secured by the company’s assets, so that if the company defaults on the loan, the bank can seize the assets, sell them, and apply the proceeds to the amount due on the loan. Unsecured debt is the second highest level in the capital structure. Holders of unsecured debt can’t lay claim to a company’s assets in a default the way a secured creditor can. Holders of unsecured debt are only paid after all holders of secured debt have been paid in full. Holders of unsecured debt can be convertible note holders, or vendors that let the company buy on credit. The third level in the capital structure is preferred stock. Preferred stock is equity, and is junior to all debt. This means if a company fails, all of the debt must be paid off before the preferred stockholders are paid. Finally, there’s lowly common stock. If a company fails, holders of common stock are all only paid after all debt has been paid off and the preferred stockholders have been paid off. So where do convertible notes fit in the capital structure? Convertible notes are unsecured debt. So, if a startup that has convertible notes outstanding fails, any holders of secured debt are paid off first, and then the holders of unsecured debt, including the convertible note holders, are paid. Having said all that, if a start-up fails, there probably won’t be a lot of assets, and the convertible note holders will likely end up with nothing or pennies on the dollar.
- High Risk Investments. Investments in start-up companies are very risky investments, and have very high failure rates (I have seen studies that peg the startup failure rate at a whopping 90%). And as indicated above, startups typically don’t have many assets (especially tech companies) and so if the company fails, the convertible note investors will likely lose all or most of their investment. Because of these risks, convertible note investors will typically want additional reward to compensate them for these risks. The additional reward in convertible notes takes form of valuation discounts and valuation caps, which are discussed below.
- Use an Advisor. Convertible notes are complex and there are many nuances. Investors are urged to have them reviewed by a knowledgeable attorney or financial advisor.
Basic Convertible Note Example. Lattamattic Technologies plans to raise a $3 million Series A preferred stock financing, but the company expects it could take up to six months to raise the Series A round. The company estimates it needs $300,000 to bridge it to the closing of the Series A financing. The company approaches some family offices, who agree to invest the $300,000 in convertible promissory notes that will convert into the Series A financing. They agree to a 5% annual interest rate and an 18-month maturity date. In six months, the company closes the Series A financing round, and the convertible notes convert into $307,500 worth of Series A preferred stock ($300,000 principal plus interest of $300,000 * 5% * 6 months).
Valuation Discounts and Caps
If you are an investor in Lattamattic’s convertible notes, is it fair that you only get a measly 5% interest for the very substantial risk you are taking? No. Valuation discounts and caps provide convertible note investors with a premium return for the risk they are taking.
Valuation Discounts. Preferred stock financings are called “priced rounds” because a valuation is established through negotiations between the company and the lead investor. These valuation negotiations can be very difficult and time consuming. In contrast, there is no formal valuation that is established for convertible notes. Instead, convertible note investors will often negotiate for a discount to the valuation of the future priced round (the qualified financing). A valuation discount in a convertible note provides that when the company closes the qualified financing (where a formal valuation will be established), the convertible note holder gets a discount to the price that the new Series A investors pay. Valuation discounts are included in most convertible notes. Valuation discounts are often around 20% and usually range from 10% to 25%. Valuation discounts are also referred to as “price discounts” and “conversion discounts.”
Valuation Discount Example. Using the Lattamattic example above, assume the convertible investors negotiate a 20% discount to the price paid by the Series A Investors. The Series A Investors negotiate a $20 million valuation for the company that translates to a purchase price of $2.00 per share of Series A stock. Because of the 20% discount in the convertible note, the convertible note holders will have their notes convert into Series A stock at a price of $1.60 per share ($2.00 per share *(100% - 20% discount)). This 20% discount is the risk premium the convertible note investors receive (including the interest on the note) for taking the risk of investing in the company.
Valuation Cap Example. Using our Lattamattic example, assume that the convertible note holders and the company agree to a $10 million valuation cap. Six months later the company holds its qualified financing which is a Series A financing. The Series A investors and the company agree to a company valuation of $20 million ($2.00 price per share). Because the convertible note holders have a $10 million cap on valuation, this means that the convertible note holders will have their notes convert into the Series A stock a price that is half ($10M / $20M) that paid by the Series A investors. This means that while the Series A investors will pay $2.00 per share of Series A Stock, the convertible note holders will have their convertible notes convert at $1.00 per share.
Discount and Cap Example. Using our Lattamattic example, if the convertible note investors had both a 20% discount and a $10 million cap, then when the company holds its Series A financing at a $20 million valuation ($2.00 price per share), the convertible note holders will take advantage of the valuation cap because it provides the best result (converting into Series A stock at $1.00 per share, while if the discount were used, the note would convert at $1.60 per share of Series A stock). If, however, the Series A financing has a valuation of $10 million (or $1.00 per share), then the convertible note holders will take advantage of the discount because the discount would then provide the best result (the note would convert into the Series A stock at $0.80 per share, while if the $10 million cap were used, the note would convert at $1.00 per share).
- Other Mandatory Conversion Events. In addition to automatically converting on a qualified financing, convertible notes will typically automatically convert in certain situations, such as the company’s initial public offering, the sale of the company, or upon the vote of a majority or supermajority of all convertible note holders.
- Optional Conversion. Convertible note investors will often negotiate for the right to convert the note into shares of common stock on certain events. These optional conversion events are (1) the maturity date, where the holder has the right to convert the note at an established price, or (2) a “non-qualified financing”, meaning a financing that doesn’t meet the definition of a qualified financing, (3) on the merger or sale of the company or transfer of voting control to a third party (a merger, sale or transfer of voting control are collectively referred to as a “change of control”), or (4) at any time at the option of the note holder into common stock at an established price (or if the company has preferred stock outstanding, into the latest preferred stock that was issued at the price per share of that round). These optional conversion features provide investors with flexibility, so upon an optional conversion event, they can analyze if converting would provide a better result than staying as a holder of a convertible note.
- Change of Control Premium. A convertible note may contain a provision that if there is a change of control (a merger or sale of the company) prior to the maturity date, the convertible note holders will receive the principal amount plus accrued interest plus a premium that is a percentage (usually 50% to 200%) of the principal amount of the convertible note. What this means is that if the company is sold, the note holder will receive (1) the principal amount of the convertible note plus all accrued interest, plus (2) an amount equal to 50% to 200% of the principal amount of the note. Investors may want both the change of control premium and an optional conversion right on a change of control, so that they can determine which would provide the investor with the better return.
From the company’s perspective, convertible notes have certain advantages:
- Fast and Simple Form of Financing. Issuing convertible notes is easier to do than issuing stock in a priced financing round, and so issuing convertible notes is faster and simpler than doing a full priced round. Priced rounds (preferred stock rounds) need a lead investor who establishes valuation and negotiates the terms of the financing. This can take a lot of time and is expensive (legal fees).
- No Established Valuation. The thorny issue of establishing a formal valuation for the company is avoided when convertible notes are used. The valuation discussion is deferred until the qualified financing occurs. One note: the valuation cap that many convertible notes have often serves as an anchor for future valuation discussions, and so in this respect the valuation cap is a proxy for valuation. If the cap is set too high, it can cause problems in negotiating valuation in the qualified round. Set too low and the cap will greatly benefit the convertible note investors and lead to dilution to the existing investors.
However, convertible notes also have certain disadvantages for companies and founders:
- Multiple Caps and Discounts Complexity. If a company issues convertible notes to lots of investors with different caps and discounts, it can create problems when negotiating the terms of the qualified financing, and can lead to very complicated capitalization tables and financing documents.
- Debt Feature can Wipe Out Founders. If the company isn’t successful and is wound up or sold at a fire-sale price, the convertible note holders will be paid out of the proceeds of the liquidation or sale before any stockholders receive any of the proceeds. Usually, if a startup fails, the convertible note holders will lose some or all of their money, and stockholders including founders often end up with nothing.
- Some Investors will Wait for Priced Round. Some investors will prefer to wait and invest in the company’s priced round. This is because they want to make sure the company will raise enough capital to meet their next milestone, or because of the added risk of investing in convertible notes.
From an investor’s perspective, convertible notes have some favorable characteristics:
- Debt. Convertible notes are debt of the company, and so if the company fails, the note holders have priority over the stockholders to any proceeds from the liquidation of the company. This is known as “downside protection.” However, as discussed above, if a startup fails, there many not be many assets left in the company, and the convertible note holders may receive nothing at all or pennies on the dollar for their investment.
- Risk Premium. Valuation discounts and caps as well as interest can provide convertible note investors with return potential that compensates the investors for the risk they are taking when investing in these notes.
Convertible notes also have some downsides for investors.
- Higher Risk than Priced Round. Convertible notes are higher risk than a priced round. This is because a priced round raises more capital than a convertible note round and so the company will have a longer runway to develop its product. The valuation discounts and caps are intended to incentivize convertible note investors to take these risks, but if the company can’t raise its priced round, the convertible note investors will likely be wiped out.
- Few Protections Compared to Priced Rounds. Investors obtain lots of different protections and rights in preferred stock financings, which aren’t present in convertible note financings. For example, convertible note holders have no voting rights, protective provisions, board rights or even information rights. For this reason, some investors will prefer to wait and invest in the priced round.
- Other Provisions. There can be lots of nuances to convertible notes and other provisions that can be included in these financings, and this post serves only as an overview. Consult with you financial and legal advisors before you invest in a convertible note financing.
- Cap Table. Where do convertible notes appear on the company’s cap table? Typically, they don’t. Usually there’s a separate tab or section of the cap table that shows the convertible debt outstanding and the discounts and caps. When the company holds its priced round and the convertible debt converts into preferred stock, then the former convertible note holders that are now stock holders will appear on the cap table.
© Allen J. Latta. All rights reserved.