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:
- 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.
- 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.
- 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.
- 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?