A few posts before I wrote about How Venture Capital Funds Works?.
Brad Feld and Jason Mendelson wrote an excellent book from the perspective of the entrepreneur
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. One of the reason to read the book is to understand the advantages and disadvantages from Convertible Notes better.
In Wikipedia the Convertible Note (or bond) is as follows described:
A convertible bond or convertible note (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features. Convertible bonds are most often issued by companies with a low credit rating and high growth potential.
This description makes it clear why convertible notes are used for StartUps because StartUps have a low (or better no) credit rating and high growth potential.
In the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist it is described as follows:
Convertible debt is just that: debt. It’s a loan. The loan will convert to equity (preferred stock, usually) at such time as another round is raised. The conversion usually includes some sort of discount on the price to the future round.
Most common terms connected to convertible notes are the discount and the cap.
Remember that a convertible debt deal doesn’t purchase equity in your company. Instead, it’s simply a loan that has the ability to convert to equity based on some future financing event. Let’s begin our discussion of terms for convertible debt with the most important one, the discount.
The idea behind the discount is that investors should get, or require, more upside than just the interest rate associated with the debt for the risk that they are taking by investing early. These investors aren’t banks—they are planning to own equity in the company, but are simply deferring the price discussion to the next financing.
The (valuation) cap
The cap is an investor-favorable term that puts a ceiling on the conversion price of the debt. The valuation cap is typically seen only in seed rounds where the investors are concerned that the next round of financing will be at a price that is at a valuation that wouldn’t reward them appropriately for taking a risk by investing early in the seed round.
Source: the book Venture Deals Smarter Lawyer Capitalist
In practice it means that some investors try to fix this problem by setting a cap on the price they will pay in the next round. In other words, as an investor, I’ll take a 20 percent discount on the price of the next round up to a valuation of $X. If you get a valuation above $X, then my valuation is $X (hence the notion of a valuation cap).
A few examples which are calculated based with the calculator of captable.io and commented based on a few other articles.
Convertible Note without Cap and 20% discount
- Easy to make deal as no valuation is needed
- Easy transaction
- Motivating for the entrepreneur to create more value (so higher valuation)
- Dumb for investors, as they are not maximal rewarded for early risks
Convertible Note with a Cap and 20% discount
- Relatively easy transaction
- Early stage, and risk of investor are rewarded
- Discussion about valuation is needed
- Less motivating for the smart entrepreneur, as he will loose shares when he is doing very well (although it is still win-win especially when the Angel joins the Series A round too)
Convertible Note with Cap and 20% discount but the cap is not reached
This is a worse case scenario (but worst case scenario is bankruptcy) as the valuation for notes was higher then the Series A investment round. For the entrepreneur it is terrible but he is also the one to blame. The Angel gets a serious share in company that doesn’t run the way it was planned. Anyway the company is still alive, the question is how motivated is the entrepreneur.
Convertible Note without Cap and but extra high discount of 50%
This is not a very common way but as you can see it doesn’t solve the problem for investors, to be maximal rewarded for early risks.
Convertible Note with Cap and but extra high discount of 50%
This is not a very common way but the Angel is rewarded for early stage risks although in this case a high discount from 50% results in the ownership percentage (7,5%) as in the 2nd example with a discount of 20%. The reason is that the discount expires when the cap is reached.
Convertible Note with Cap and 20% discount with 2 angels
In this example you can see that the entrepreneur “looses” quiet some ownership if you have 2 angels that take the risks. On the other side there is a serious investment in the early stage, and very risky stage which is rewarded.
Convertible Note with Cap and 20% discount with 2 angels but only one reached
This example means that there was a very early stage investment of an Angel but the 2nd angel invested later at a much higher valuation. Because this valuation didn’t reach the cap, the ownership is that big. This looks good for the entrepreneur but in fact the valuation as agreed with the 2nd Angel was not even reached during the series A investment.
Then some more opinions about convertible notes.
At first my opinion if you compare convertible loan vs equity
- Easy to make transaction
- Easier to make a deal
- Less legal fees (but this is possible to negotiate with lawyers)
- Harder to “sell” with an exit
And what do Brad Feld and Jason Mendelson say in the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist:
Arguments for convertible notes
Most fans of convertible debt argue that it’s a much easier transaction to complete than an equity financing. Since no valuation is being set for the company, you get to avoid that part of the negotiation. Because it is debt, it has few, if any, of the rights of preferred stock offerings and you can accomplish a transaction with a lot less paperwork and legal fees
The debate goes on endlessly about which structure is better or worse for entrepreneurs or investors
One of the primary reasons for an early stage investor to purchase equity is to price the stock being sold in the round. Early stage investing is a risky proposition, and investors will want to invest at low prices, although smart investors won’t invest at a price at which founders are demotivated. As a result, most early stage deals get priced in a pretty tight range.
Then the opinion of Adam Quinton who warns entrepreneurs as investors as well for Convertible notes in his article Be Wary of Startup Convertible Notes.
Caution for investors:
- Receiving worse terms than other investors
- Converting into preferred stock without the desired rights
- Not receiving the same rights as other investors when the debt converts
- Converting into common stock instead of preferred stock
- Having the loan repaid despite a successful exit
- Having the loan repaid despite the company doing well
- Having other investors force an unfavorable decision
Caution for entrepreneurs:
- Little Value Add from Investors
- Reduced Incentives to Help
- More Preference
- Less Discipline
- Two Words: “Full Ratchet”
- Deceptive Dilution
- Lost Allies
Another article in favor for the entrepreneur is One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes. To be honest I don’t agree with it, as I think extra risk in early stage maybe rewarded. But as an entrepreneur you can try to negotiate it off course.
In general take the benefit of this knowledge and do your own research before you start the negotiations (and even talks with lawyers).