4 Reasons Investors Shouldn’t Do Convertible Notes

Over the last week the topic of convertible notes came up in two different conversations. Convertible notes are essentially a loan to a startup that converts to equity on a certain date or if the startup raises a certain amount of capital. Convertible notes (and subsequently the safe) became popular several years ago as investors wanted to move fast, keep initial legal costs down, and defer the valuation topic to the next investor. Basically, a much simpler transaction. Only, it put convertible note holders in a poor position.

Here are four reasons investors shouldn’t do convertible notes:

  1. Misalignment on Valuation – Convertible notes often have a cap which represents a maximum valuation for the investor (e.g. a cap of $3 million such that if the startup raises money at a $4 million valuation, the investors’ debt converts at the lower of the two valuations). Only, the convertible note investor is incentivized for the startup to raise money at a lower valuation so that they’ll get more equity for their money (assuming everything else about the terms is equal). Entrepreneurs want to raise money on good terms and good valuations, but that isn’t aligned with the convertible note holders as they have negative benefit with a higher valuation.
  2. Limited Initial Upside – Most convertible notes have a discount of 20% to the next round of financing (e.g. if the round is at a $5 million valuation, the convertible note holders get their equity at a $4 million valuation as that’s 20% less). Yet, raising convertible debt doesn’t guarantee a subsequent round of financing happens quickly. If the financing round takes 6-12 months (or more), the investor is only getting a paper return of 20% for taking on outsized risk. Investors typically want to see their portfolio companies raise money each round at a minimum of twice the last valuation.
  3. Lack of Future Qualified Financing Event – Most convertible notes only convert at a qualified financing event (some have a conversion date far in the future). If the startup doesn’t raise more money, or can’t raise more money, the investor is essentially stuck with a low interest loan in a high risk investment.
  4. No Governance – Convertible notes are simple debt with limited covenants and no governance rights. Ideally, the startup will raise a “normal” round and have the governance that comes from a board and a lead investor in the future, but there’s no definitive timeline. Without governance, the entrepreneurs can do what they please with the money with limited recourse.

Investors would do well to understand the pros and cons of convertible debt. Personally, I require equity and don’t invest via convertible debt.

What else? What are some more reasons why convertible debt can be worse off for investors?

One thought on “4 Reasons Investors Shouldn’t Do Convertible Notes

  1. It’s funny — you can find about an equal number of intelligent posts like this, one group saying why convertible notes are terrible for investors (as above), and the making the case that they are terrible for the entrepreneurs (e.g., Fred Wilson at avc.com)! What this means, I’m not sure. Maybe that the situation is not so clear cut.

    All of these posts tend to ignore the compelling reasons that entrepreneurs turn to convertible notes.

    Note documentation is easy to understand (the number of moving parts is quite low) and, most importantly, relatively inexpensive. By contrast, doing an equity round generally involves changes to a company’s certificate of incorporation and — if any of the standard document sets are used (most of which I find to be investor-favorable to a greater or lesser degree) — three or four additional, long documents will also be involved. The legal fees easily get to $20K or more, when both company and investor counsel are included.

    Personally, I’ve done much lighter equity documents for startups, quite inexpensively, but these are for seed rounds, where the company tends to be in the driver’s seat and a lot of terms can be left out. I am sure that if a VC investor were involved, they would find them lacking (in their view) sufficient protections.

    The problem with equity rounds is complexity and cost, and until those issues are addressed, companies will keep using notes and SAFEs, even if in some cases they have terms that may be less than ideal for one side or the other.

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