Example

Here is an example of what happens in a typical convertible note transaction: A startup is looking for seed money to get the company off the ground. The company finds an investor willing to invest $50,000 in exchange for a convertible note. The note specifies that the company will convert the $50,000 of debt into shares of the company at a 20% discount upon the acquisition of an additional $1,000,000 in financing. If the company is unable to raise $1,000,000 then it must repay the $50,000 debt to the investor with interest. Later, the company raises the additional $1,000,000 by selling shares at $1.00. Now that the conversion event has occurred, the $50,000 debt plus interest owed to the investor is converted into shares of the company ($50,000/$.80 per share = 62,500 shares + additional shares for interest accumulated up to the date of conversion). The company no longer owes the $50,000 debt and the investor owns a portion of the company.

Advantages to Convertible Notes

There are several benefits for the startup company in using a convertible note. The main advantage is delaying the initial valuation of the company. The valuation discussions between the company and the investor can be a stressful, time-consuming endeavor, due to the difficulty on placing a value on an early stage venture still in the planning phase. The convertible note offers startup companies a quick resolution to this problem of raising initial capital. It is often simpler, quicker, and costs less in legal fees than conducting a full sale of Series A Preferred Stock. By using a convertible note, the startup company can have access to capital almost immediately and delay valuation discussions until further down the road when they need to raise additional money. Since the company will also spend less time raising and closing the initial funding round, they will be able to spend more time developing the company into a successful operation.

A convertible note offers several advantages for the investor as well. The main advantage is that in exchange for taking the early risk, the investor will receive stock in the company at a discounted rate. Another advantage is that the investor receives some additional protection in its investment with a convertible note as opposed to a straight equity investment. If the company folds before it is able to acquire additional financing and is unable to accomplish the agreed upon goal, then the investor is a creditor. In the event of a company liquidation, creditors get paid back first, before shareholders. Also, the investor may structure the note to be secured by company assets, which would allow the investor to foreclose on the assets of the company to recover its debt. If the investor were a shareholder at this point, the investment would most likely be a complete loss.

Disadvantages to Convertible Notes

While a convertible note can be a great option for a startup company, it is not always the best option. There are some disadvantages with convertible notes, just as there are with all methods of raising capital. One disadvantage of using a convertible note is that once the investor’s debt is converted into stock, the founder’s percentage of ownership in the company is diluted, as happens in any equity financing. Another disadvantage is that when it comes time for the valuation of the company in the next financing, the original investor may seek a lower valuation, which they may or may not have any power to influence. The company wants to maximize the pre-money valuation for the next round to minimize shareholder dilution as much as possible. A lower valuation gives the investor a greater ownership percentage of the company, a higher valuation gives them less. This misalignment of interests could have a negative effect on the company.

The investor faces some disadvantages as well. During a conversion, the pre-money valuation of the company and the percentage of the company received by the initial investor are inversely proportional. This means that the more successful a company becomes between issuance of the convertible note and the conversion event, the higher the pre-money valuation of the company during the next qualified financing. In turn, a higher pre-money valuation means the initial investor will receive a smaller percentage of ownership in the company upon conversion. The investor is sometimes caught between wanting the company they invested in to succeed and not wanting it to become too successful and therefore diminish their percentage of ownership in the company upon conversion. Investors often cite this misalignment in interests as a reason for refusing to do convertible notes. However, the counterargument to this point is the old adage, “Would you rather own 10% of a $1B company or 100% of a $1M company?” Another disadvantage for the investor is that if the company is unsuccessful and unable to acquire additional financing, the company might not have any significant assets to be liquidated or foreclosed on, making it nearly impossible for the investor to recoup the money owed on the note. Although being a creditor and having the ability to foreclose upon the assets of the company can be an advantage, the ability to foreclose is meaningless if the company has nothing to foreclose upon. Because of these disadvantages, many investors are often unwilling to use convertible notes.

Conclusion

If you are an entrepreneur looking to start and fund a new business or an investor seeking to get the most of your investment, a convertible note may be an option worthy of your consideration. Each company and each investor has different requirements, and each investment opportunity is unique, so the advantages and disadvantages of a convertible note will vary in each situation. To discuss whether or not a convertible note is the best option for you, please contact the Copeland Law Firm at 512-850-4529 or info {at} copelandfirm(.)com. Whether you are a startup or an investor, we offer a wide array of services, and would be happy to discuss all of your available funding options.