Convertible Notes

There has been a lot of noise about how most seed stage deals are being done through convertible notes. The convertible note was really intended as an instrument for a “bridge financing” — when an equity round was imminent, and likely to occur, but the company needed some money in the interim. In such a scenario, it made complete sense to have a debt instrument, where the investor converts them into equity when the financing occurs. As the debt-based investment is made close to an equity round, there is no need to have a valuation-based factor in the note. In a worst-case scenario, where the intended equity-based fund raise fails, the very nature of the instrument being debt-based insures and guarantees that the bridge investor would get priority in case of a liquidation of the company’s assets.

However, somewhere along the way, the usage of a convertible note changed. This primarily happened due to the higher fees and cumbersome process associated with doing an equity round. The convertible note hence came to be perceived as the easier, cheaper, and faster option. Today, the convertible note is no longer a bridge, but has all too often become a pier.

An uncapped convertible note misaligns the incentives between the founders and the investors. Although both the founders and the investors have the common objective of getting the company funded, there is a basic misalignment of incentives when it comes to valuation. While the interest of the founders is to maximize the valuation of the company at the time of a follow-on financing (thereby minimizing equity dilution), the investors' motivation is to minimize the valuation of the company so that the investment committed as part of their note convert in to as large a piece of the company as possible. This concern can be addressed by putting a cap in the note for the pre-money price for conversion, which is the genesis of the term "capped notes". Although entrepreneurs prefer the notes as they defer the process of a valuation to the company, once a cap is put in a note, it effectively prices the company.

Although notes have fewer rights associated with them, they come with one big caveat. Legally, the note is a debt instrument and can be called upon maturity. It is in essence equivalent to being a liquidation preference that is typically seen in a preferred equity. In a lot of ways, the note is not as strong a commitment from investors as equity investors, as they still have the option to pull their money out. By contrast, when investors buy equity, they are fully committed, and usually do not have an option to get their money back before a milestone and their only choice is to help the company succeed or end up losing their money 

Notes have some interesting ramifications for investors as well. When an investor buys equity in a priced round, the capital gains clock on that stock starts as of the date of investment. However, in the case of a note, and especially with long maturity dates, the capital gains clock does not start ticking till the note converts. The intensity is felt at the seed and angel level where a lot of startups make exits. Let us say a company liquidates with a positive outcome. In the case of equity holders, there would be long-term capital gains and they must pay 15% on the gains. However, for a note holder, since there is a chance that either they have not converted yet, or if it had converted, it may not have been 1 year since the conversion. In this case, the note holder would end up paying 35% on short-term capital gains.

My purpose in writing this post is to incite a bigger discussion on this topic and to solicit more opinions and feedback. I would love to hear from founders and from investors on their view on convertible notes.