A convertible note is a short-term debt that can be converted into equity (typically preferred shares) of a company. It has advantages and disadvantages for both investors and the issuing company. Michael Hool, of Hool Coury Law Group, focuses his legal practice on working with investors and emerging businesses from startup to exit. He took part in a Q&A for Invest Southwest to help readers understand convertible notes.
Q: How did the idea of convertible notes originate?
A: Convertible notes started out as a device to bridge the early stage company to the Series A equity round when a venture capitalist investor (“VC”) is ready to fund a business. Under that historical approach, if a VC likes a company, he or she may loan funds to the company while the VC completes due diligence before its first round of equity financing, which can take a long time – sometimes as much as 120 days. The VC will loan money to cover the company’s funding needs for that period. In that circumstance, convertible notes were a funding bridge until the preferred round of equity is completed by the VC.
In the last seven to ten years, a lot of early stage companies started doing convertible notes even when no identifiable funding source for Series A equity financing was on the horizon. Today, the convertible debt is used primarily as a device to bridge differences in the opinion of valuation at a time when a company is in its early stages and very difficult to value.
Q: How does a conversion cap work?
A: Let’s talk about conversion discount first. That’s when a company says, if you give us $100,000 today, we’ll give you 20% off our Series A round of preferred equity shares when we finally set the valuation for those shares in a negotiation with the later investor. If the shares sell for $1 each, the investor who provided the convertible debt would convert the debt to the Series A stock at a price of 80 cents per share.
A cap is a mechanism to protect the investor. Between now and the next two years when the note is due, the investor has no idea if the company is going to raise capital through equity and what the price will be. He or she is at risk that the longer the company takes to do its equity round, the company may have gone up in value quite a bit. The cap is designed to protect the early note investor from having to convert at a high price because the company didn’t do the Series A round fast enough or if the value simply shot up faster than everyone thought it would. So, in addition to the conversion discount, the convertible note typically might have a cap on the conversion price of, for example, $2 a share. This is the highest price at which the investor will pay for the Series A stock when the note converts. This is an important tool to protect the investor (who took the early risk when he or she loaned the money) when the Series A round might be priced at a much higher value, like $ 5 or more per share.
Q: Do entrepreneurs worry about giving up control with priced equity rounds?
A: In that early stage, you really don’t get investors trying to get control. A Series A round is like an earlier seed round in Silicon Valley. In Arizona, before you bring in the A round, you are talking about a funding gap typically anywhere from $100,000 to $1 million to get a company going after exhausting friends and family. It would be pretty rare to have angels asking for control that early. Angels aren’t interested in control. They don’t want to run the business. They just want to have some protections and are often interested in adding value based upon some affinity or experience in the field. Usually, it’s not a very efficient process to negotiate control at this stage, and you want to keep things simple and transaction costs down.
Q: So, do conversion discounts and caps take all the risk out of convertible notes?
A: No. One question is what happens if you are an investor and put money in and the company doesn’t have cash to pay you back, and they haven’t sold any preferred shares. What do you convert your note into?
This circumstance typically follows one of two paths. One, convert to common shares. Whatever the discount for preferred shares was, the investor will take it on the common shares. Whatever the discount was, say it’s 25%, then it’s 25% off the last sale of common shares at the last price the board determined. Sometimes notes have a bigger discount if the note has to convert into common. The other way it’s handled is to spell it out in a term sheet if no equity is sold, the company will create a preferred stock that gives those investors preferential payment during liquidation.
Q: Who should do this type of fundraising? Is it for everyone?
A: I am a believer of selling shares that have a simple liquidation preference if you can agree upon value as the first choice. If you raise $100,000 from a couple of investors and that’s all you need, selling common shares is the easy way to do it if your investors are willing. Keep the cap table simple. Keep ownership structure simple. Keep the rights and preferences on the stock in this early stage very simple. The only time you add bells and whistles is if there is a business reason to do so. Sometimes that business reason is the fact that the investor does not agree on the company’s valuation. In that case, to get the money the company would look at issuing convertible debt with a cap if the angel investors are willing to invest in that structure.