Convertible Notes – An Angel Investor’s View

Overview

Not so long ago, when one invested in an early startup, it was almost always through the purchase of preferred stock or equity in the company. An exchange of cash for a small percentage of ownership. Neat and tidy, everything on the table, no loose ends. Then, over time, founders (with the help of incubators and accelerators) decided that these equity instruments were becoming too difficult and time consuming, especially with respect to the negotiation of the price of the round and, to some extent, the preferences required by some investors. The “simplified” instrument that most companies started to use was the convertible note.

Convertible notes quickly became de rigueur in the startup community. They are, ideally, debt instruments that offer the investor interest payments in exchange for cash invested in the company. On the successful achievement of certain milestones, the investment (plus the interest earned) is automatically converted into ownership in the company. The key milestone generally being the closing of a subsequent equity investment round. Allegedly, if the company fails to raise an equity round in a specified timeframe, the investor can get their money back. This is supposed to be the advantage for the investor but is, in fact, a useless provision. If the company can’t raise a round, they have more than likely spent all the cash they have leaving nothing in the till to return to investors.

Initially, convertible notes did make things simpler for the founders of the startup. They could kick the valuation discussion down the road and the paranoid founder could withhold any control and financial preferences from their early investors. Unfortunately, these early, simple convertible notes were minefields of problems for angel investors. Foremost among these:

• They created situations where investors might only get their money back even though there was a large exit for the founders. Think of an exit that happens before a conversion takes place.
• They did not specify any control provisions or establish a board (every company needs one). No oversight.
• They often didn’t recognize the level of risk taken by the early investors with an appropriate combination of discount  and conversion restrictions at the next financing round.
• Because the investment is debt and not equity, they kept the investors from starting the clock on capital gains treatment for the investment until the conversion took place.

To address these problems, investors negotiated new provisions in the notes to patch the holes which, in turn, made the convertible note documents increasingly complex and ultimately created documents at least as complicated as the equity investment instruments that they replaced.

Now, instead of discussing the valuation of the company and specific preferences of the preferred stock in an equity round, the cap on the note (the maximum conversion price), the discount (the reduction in price upon conversion), and the term of the note (when and how conversion takes place) need to be negotiated (some good descriptions of these can be found here).

Convertible note documents have ballooned into multi-page, complex forms that are not only negotiated just like their equity-based brethren, but now carry legal costs that are similar as well, taking away much of the advantage that was sought when they were widely adopted in the first place. In fact, they don’t even succeed any longer at their primary goal of kicking the valuation discussion down the road since the negotiation of the cap on the note has replaced that pretty much 1:1.

The realization that convertible notes are no longer either cheap nor fast has brought about several openly available standardized equity financing instruments like Series Seed, Techstars Open Source Model and others that promise to make a priced round even cheaper and faster than a current, complex convertible note. In my experience, and sadly, these documents are not changing the landscape much.

OK, that’s my rant. For a while, I refused to invest in converts. I wasn’t the only investor around who felt that way, but most didn’t care or push back. The debt instrument took hold and is here to stay. At least for a while. Now, I see very few seed deals that are not structured as convertible notes. Those that aren’t are generally led by institutional investors who often require an equity instrument to do an investment.

There is just so much fighting of the establishment that one can do and, as such, I’ve conceded that if I am to remain an investor, I have to adapt. That doesn’t mean I have to roll over, though. As such, I’ve created a set of criteria for myself when it comes to reviewing the convertible notes of potential investments. There are certain parts of a note that I like to see and some I don’t like. More importantly, there are parts that cause me to negotiate strongly and, ultimately, walk away if they are not added, removed or modified. I’ve tried to outline each of these below.

For angel investors reading this, I’d appreciate if you’d add your thoughts on what I’ve missed and where I’ve overstepped. For founders of startups, I hope you’ll look at these items as guidelines when you’re putting together your note. My intent is not to create an investor-biased instrument, but to fill the holes left by current convertible notes; to shed light on why some terms don’t work well for angel investors and to suggest how to change them so they work better. I don’t believe that any of the guidance I have or changes I recommend should be detrimental to the founders of the company. Speak up if you disagree.

Discount and Interest

Seed investors take a significantly higher level of risk than later stage investors. Let’s face it, the vast majority of startups fail and most of those fail early. In an equity investment round, the risk level taken by angel investors was built into the valuation of the company. Since this is not part of the note, then the investment risk has to be recognized through another avenue. This is the importance of the discount. A discount rate of 20% is pretty standard, but is it appropriate that the seed investor pays 80% what the next round’s investors pay when there might be a year between investment rounds? Probably not. So, the discount rate needs to be judged alongside the cap on the note. The combination of the two should recognize the risk taken by the early investor. That said, a discount rate of less than 20% is pretty big red flag for me.

On interest rates, I usually see 5-6%. I don’t focus on these too much because that’s not why I’m making the investment. Still, if it’s much outside this range, I’ll want to know why.

Cap

First and foremost, there must be a cap on the conversion. Again, why should an early investor take the risk of an early investment only to have someone else decide on the actual value of that investment somewhere down the road?

There is no absolute on the cap, of course. It depends on the company’s stage and what’s happening in the overall market. The cap should reflect the projected value of the company at the approximate time of the next financing, discounted to take the risk of the market and execution into account. Good luck with that. Really, it’s the number that in combination with the discount will get investors to fill your round. Hopefully, you can begin to see why negotiating this is no more efficient than negotiating an actual current valuation

Events Prior to Conversion

One of the biggest problems with convertible notes from the investor’s viewpoint is plugging all the potential scenarios that can take place between investing via a note and the conversion of the debt to equity. For example, if the company is sold prior to conversion, does the investor simply get their money back without recognition of the value of their investment? This situation is covered naturally in an equity round, but not in most convertible note documents.

As such, the note must specify that any change of control of the company (aka sale of the company or liquidation event) before conversion has taken place triggers a capped and discounted (as per the terms of the note) conversion into common shares in the company immediately prior to the execution of the corporate transaction. What this means is that the investor’s debt will be exchanged for equity according to the terms of the note, making the transaction a proxy for an equity investment round.

If the transaction is for less than the conversion cap, then the investor should have the right to receive a multiple of their investment. This can be on a sliding scale based on the time between their investment and the transaction. I have seen a fixed multiple of 2X applied to cover this gap.

Closing of the Note

The convertible note should not remain open for a long period of time. Sometimes, company founders will create a note and continue to take money under the terms of the note for an extended period of time. Since the terms of the note represent the level of risk taken and time, generally, reduces risk, it’s not fair for later investors to get the same terms as substantially earlier ones. Therefore, notes should be closed within 90 days of their opening to recognize the risk being taken by the early investors. If a note remains open for a long time, many angel investors will do their best to be the last money in which can make it difficult for the founders to raise the cash they need.

Pari Passu with Future Notes

It used to be that the early seed round was done with a note and the subsequent rounds were equity deals. These days, angels are seeing multiple rounds of convertible notes. When this happens, it’s important that the original note holder ensures that any more favorable terms in the future notes apply to the original note as well. Why should the people who took more risk by investing early receive fewer benefits?

To be clear, this does not apply to retrofitting the terms of an equity investment to original note holders. On conversion, the note holder will become equity participants via the conversion and receive the same terms, with some exceptions mentioned below, as the participants in the equity round.

The Major Investor Clause(s)

Many note documents include a class of investor referred to as the Major Investor. The Major Investor is usually granted rights that include guaranteed information, inspection rights and the right to invest in the next round of funding at their pro rata level at minimum. Effectively, the Major Investor clause(s) give the company and/or investors the right to preclude non-Major Investors from getting information or investing in the next round. As an angel investor, this is a huge negative. If things are going well, I may not have the ability to invest further. I’m not sure how that benefits anyone. No such clause should exist. If it does, I’ll ask for a side letter including me as a Major Investor.

I cover this thoroughly here.

A permutation of this that is regularly found in notes covers what is often known as the Requisite Holders. Sometimes, I’ll find the description of the rights of a Requisite Holder at the end of the note buried in the boilerplate stuff that no one ever reads. Here’s an example:

Any provision of the Notes may be amended or waived by the written consent of the Company and the Requisite Holders.

Where the group of Requisite Holders may be defined as the largest investors in the round. So, basically, certain investors may change the terms of the note at any time even to the extent of making the terms of the note different for each investor. The especially bad part of this, as I mentioned, is that this clause is often found at the end of the note, where no one is really paying attention. Why would I agree to this? Does this serve the company?

Conclusion

Whew! That was long. If you’ve read this far, I hope it was helpful. I’d like to believe that this is a treatise that will reverse the tide of the use and overuse of convertible notes. Of course, I know it won’t. So, at the very least, if this helps a few angel investors be more diligent about convertible note documents and convinces more to push for equity investments instead of debt, then I’ve done my job.