Convertible debt is commonly used in seed stage transactions, and for anything but friends and family, or a true 90 day or less bridge, I cannot understand why anyone would use these to fund a company, regardless of whether you’re an investor or founder – it’s equally bad for both.

Fallacies about convertible debt - peter adams

There are a lot of otherwise smart people out there who continue to support fallacies about the

 benefits of convertible notes.  I’ll walk you through the claims and show you how they are not only wrong, but are the exact opposite of many people’s beliefs.

 

Fallacy #1:  Convertible Notes are Cheaper than Preferred Equity Deals.

This belief comes from a shallow idea of the cost of a note.  While it’s true that the legal costs for doing a note are $2500-$5000 in many markets and the cost for doing a preferred equity round can be as much as $10,000 to $20,000, there are other costs to consider.

If the note is for two years, for $1 million at 8% interest, then the entrepreneur is going to have to pay $166,400 in interest.  Some will argue that this is rarely paid in cash, but it is still a huge amount of dilution for the company and represents a real cost to them.  So, when does it make sense to “save” $15,000 when it costs $166,400 to do so?

The other part of the fallacy of this thinking is that the note cost is the only legal cost.  In fact, the entire premise of the note is that it will convert into equity when the company has a priced round, usually of $1 million or more.  At that time, the company will still have to pay the $10,000-$20,000 PLUS the original $2500-$5000 that they paid for the note originally, That’s right – the founder is really going to have to pay for both, resulting in 25% HIGHER legal costs than just doing an equity round in the first place.

 

Fallacy #2: Convertible Notes are Easier than Preferred Equity

It’s true that a note is only a few pages and very few terms to negotiate and Preferred Equity requires changes to multiple documents; the term sheet, subscription agreement, changes to the articles of incorporation, etc., but in the long run, convertible notes can end up being much more complicated and require a lot of legal time to figure out the ambiguous outcomes.

 

Let me start by saying that “simple” does not mean “best”.  Leaving major terms and issues undecided and unaddressed helps neither the founder nor the investor.  I recently had a portfolio company that almost went out of business for no other reason than that they had used convertible notes injudiciously and they found themselves in default on multiple notes simultaneously.

 

Let’s just consider a simple case of convertible debt vs. preferred equity in two rounds.  Let’s ask ourselves, how many shares does each round of investors get and how many does the founder get?  (Note that this conversation doesn’t occur until conversion, so many founders, attorneys and investors don’t think about these until it’s too late.)

How Many Shares do the founders have after these three rounds?

How many shares do Round 1 investors have?

How many shares do Round 2 Investors have?

How many shares do Round 3 Investors have?

 

Convertible Note

10 million shares authorized and 1 million shares issued to founders at start.

Preferred Equity

10 million shares authorized and 1 million shares issued to founders at start.

Round 1:  $1 million convertible note, 8% interest, 20% discount, $4 million valuation cap.

Round 2: $2 million convertible note, 8% interest, 20% discount, $6 million valuation cap.

Series A Conversion with Priced Round: $5 million Preferred Equity with $10 million pre-money valuation

Round 1: $1 million preferred equity with $4 million pre-money valuation.

Round 2: $2 million preferred equity with $6 million pre-money valuation

Round 3: $5 million Preferred Equity with $10 million pre-money valuation

Round 1: Founders 1 million/ Investors 0

Round 2: Founders 1 million/ Round 1 Investors 0, Round 2 Investors 0

Round 3:  Founders 1 million shares

Round 1 Note holders convert at the better of 20% discount from the priced round or the valuation cap.  Since 20% discount from $10 million would be $8 million, they will take the valuation cap at $4 million.

But wait – we have to calculate Round 2 simultaneously.  They would also take the valuation cap at $6 million, since that’s less than the 20% discount at $8 million.

Now, the Series A investors get 33% for their $5 million on $15 million post-money, right?

Or, since the first two notes are now converting, this round is actually $1 million from Round 1 plus $2 million from Round 2 plus $5 million from Round 3, so the total is $8 million on $10 million pre-money.

So, how many shares do each of the investors get?

Round 1 is $1 million on $4 million cap, so they get 20%

Round 2 is $2 million on $6 million cap, so they get 25%

Round 3 is $5 million on $18 million post-money, so they get 27.8% of the company.

The Founders get what’s left – 27.2% (1-.333-.25-.2)

That works out great, unless the Series A investor has negotiated $5 million on $10 million pre-money for 33.3% of the company.  That’s not technically how it should work since the post-money valuation is $18 million, not $15 million. The Series A investor might want to come in as if the first two rounds were equity and theirs would be the only new money coming in.  This is called “The Golden Rule” – he who has the gold makes the rules. In that case, what does Round 1 get? They should still get their 20% since that’s what they negotiated, and Round 2 should get their 25%. So, here’s how the percentages should work out in this scenario:

Founders 21.7% (1-.3333-.25-.20)

Round 1 20%

Round 2 25%

Series A 33.33%

Alternatively, the Series A investor might require that the investors in the first two convertible notes take the dilution hit instead of the founders.  Or they may figure out a way to share the dilution between early investors and founders. In these scenarios, the people who took the greatest amount of risk can be unfairly treated by later round investors who come in after the deal has been de-risked.

Believe it or not, there are still other ways that this scenario can be calculated and it gets even trickier if there is a carve-out for an employee option pool.   But the point is that there is a lot of ambiguity and this can result in higher legal costs and difficult negotiation after the fact.

Ok, so now we have to turn these percentages into shares.  For the first scenario, the only party to the transaction that we know how many shares they have is the founders at 1 million.  We know that they will own 27.2% of the company, so we need to find the number that 1 million is 27.2% of which will be the total number of issued shares after Series A.  Then we can just apply the percentages to see how many shares each party gets.

So, 1,000,000 divided by .272 gives us a total of 3,676,471 and the shares would be distributed as follows:

Founders = 1,000,000

Round 1 = 735,294

Round 2 = 919,118

Series A = 1,022,059

Round 1: Founders 1 million, Investors 250,000 (Note – investors own 20%, having invested $1 million with $4 million pre-money/$5 million post-money.

Round 2: Founders 1 million, Round 1 Investors 250,000, Round 2 investors 416,667 (Note – Round 2 investors own 25% having invested $2 million with $8 million post-money and 416,667 equals 25% of the total shares outstanding)

Round 3: Founders 1 million, Round 1 investors still have 250,000, Round 2 Investors have 416,667 and Round 3 Investors get 835,836 (again, 835,836  is 33% of the company since Round 3 Investors put in $5 million with $15 million post-money, so the calculation is easy)

 

So, between figuring out the math and negotiating all the ambiguities between the parties, doing the conversion on a convertible note is much more complex and challenging than just going through a vanilla Series Seed term sheet for Preferred Equity.  Anyone can read Venture Deals to learn about the terms and then work with their attorney to come up with a reasonably negotiated term sheet. That’s a lot easier than going through all the headache and ambiguity of converting complex convertible notes.

 

* BlockChain ICO Note:  one more complexity that is becoming more common is that companies are choosing to do an Initial Coin Offering (ICO) rather than going to Series A.  This can mean that the note never converts because there is no priced round to drive the conversion. Again – the complexity is much greater on convertible notes!

 

Fallacy #3 You can Avoid Valuation by Using Convertible Debt

 

Many people falsely believe that they can “kick the can down the road” on valuation by using convertible debt and then letting the Series A investors set the price and terms.  While this may make sense when friends and family are investing, angel investors who are investing for profit rather than family or friendship are going to need to have a valuation cap if they use a convertible note.  You may recall that in the examples above, the cap was always lower than the discount, so if investors had used an “uncapped note” without a valuation cap, they would have overpaid for their investment by millions of dollars!  For that reason, virtually none of the notes done today are done without a valuation cap, so there is still valuation work to be done to calculate what the cap should be.

 

While many recognize the need for a valuation cap on the note, many people do not understand how to calculate the valuation cap.  The formula for calculating the cap is easy:

Valuation Cap = Equity Valuation

 

That is to say, the valuation cap is calculated in exactly the same way that we calculate the equity valuation for a company when we do a preferred equity round.  

 

Venture backed companies grow as much as 2X in value every year – it would be injudicious for anyone to put their capital at risk to invest in a convertible note with a return of only 20%.  At that rate, the angel investing community would pack up their bags and go home when calculating the cumulative losses in their portfolios and lack of tax benefits.

 

I have heard no argument for why the valuation cap should be anything more than what the valuation would have been if it were an equity round.  If anything, it should be lower because of the lack of tax advantages for gains or losses to investors which can cost 20% difference in terms of after tax cash in the bank because of penalties for using convertible notes vs. equity.  (See Section 1202, Section 1244 and Section 1042 of the IRS code to understand the benefits to investors investing in preferred equity deals that are not available to convertible note investors.)

 

Valuation is a function of risk.  It makes sense that the value an investor pays should be tied to the risk AT THE TIME OF INVESTMENT.  Some get confused by thinking that the value should be set at the time of conversion, once the investor’s capital has been put at extreme risk in order to reduce risk for future investors and to increase value for the founders.  There is simply no rationale that says that value should be set at a future date when risk is lower and even less rationale to argue that a 20% discount off the de-risked value would be appropriate.

 

Conclusions

While I’ll grant that there are a few narrow uses for convertible debt today, the widespread use of them in the startup and seed stage investing community is dangerous and unjustified for both founders and early stage investors.  Attorneys should understand these fallacies and lead their clients to preferred equity deals that will better serve the needs of startup founders and investors.

 

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