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Convertible notes explained

What is a Convertible Note?

A convertible note is short-term debt that converts into equity. In the context of a seed financing, the debt typically automatically converts into shares of preferred stock upon the closing of a Series A round of financing. In other words, investors loan money to a startup as its first round of funding; and then rather than get their money back with interest, the investors receive shares of preferred stock as part of the startup’s initial preferred stock financing, based on the terms of the note.

Why Can’t a Startup Issue Shares of Common Stock to Investors?

It can. In fact, many incubators like Y Combinator and TechStars are issued shares of common stock for their initial investment (usually about $20,000). Friends and family are also often issued shares of common stock. Most sophisticated investors, however, will not accept shares of common stock for their investment and will push hard for shares of preferred stock, with special rights (as discussed below).

In addition, the issuance of shares of common stock creates three potential problems. First, the founders risk substantial dilution because it is often difficult for the founders and the investors to agree on a valuation for the startup and, accordingly, to agree on the percentage ownership the investor will receive. For example, if a startup is merely two guys and an idea, how much equity should an investor receive for a $100,000 investment? 10%? 25%? 50%?

Second, there may be tricky tax issues depending upon the timing of the investment. For example, if two co-founders are issued shares of common stock for a nominal purchase price upon incorporation, and investors pay substantially more for their shares of common stock at the same time or shortly thereafter, the IRS may impute a much higher value on the shares issued to the founders and deem the excess amount over the purchase price a form of compensation — and therefore taxable to the founders as ordinary income. Third, the issuance of shares of common stock may cause potential problems with respect to stock option grants because the underlying value of the shares of common stock (i.e., the “strike” or “exercise” price) will have been established. The goal, of course, regarding option grants is to price the options as low as possible so that the option recipients are incentivized and are able to adequately share in the increased value of the company that they help create. A high strike price undermines that goal.

How Does the Issuance of Convertible Notes Address These Problems?

One of the key advantages of issuing convertible notes is that the valuation issue is kicked down the road until the Series A round of financing – when there are a lot more data points and thus it’s much easier to value the startup (i.e., price the round). Accordingly, the issuance of convertible notes disposes of the foregoing three problems. Again, a convertible note is a loan (debt, not equity). A valuation of the startup is thus unnecessary; and, if there is no valuation, there are no problems of dilution, taxes and option pricing.

What are Some of the Other Advantages of Issuing Convertible Notes?

Speed, simplicity and cost. Indeed, a startup could close a convertible note round in a day or two by merely issuing a 2-3 page promissory note, which could cost as little as $1,500-$2,000 in legal fees (or a little more if a note purchase agreement is also executed, which is customary). On the other hand, the issuance of shares of preferred stock is complex, and it can take weeks to negotiate all the terms and documents — with legal fees in the neighborhood of $10,000 – $30,000 or more (depending upon whether the investors insist on full-blown Series A-type documentation, as opposed to stripped-down documentation like the “Series Seed,” discussed below).

Another significant advantage of issuing convertible notes is to avoid giving the investors any control. When investors receive shares of preferred stock, they are typically granted certain significant control rights, including a board seat and veto rights with respect to certain corporate actions (such as the sale of the company) pursuant to so-called “protective provisions.” They also have certain key rights as minority stockholders under applicable State law (usually Delaware).

Convertible noteholders are rarely granted control rights (and have no minority stockholder rights). For example, in Fenwick & West’s 2011 Seed Financing and Short Term Loan Survey (the “Fenwick Survey”), convertible noteholders were granted a Board seat in only 4% of the seed financings; while preferred stockholders were granted a Board seat in 70% of such financings.

Finally, another advantage of issuing convertible notes (and probably the least understood and most important) is the extraordinary flexibility they offer in connection with “herding” prospective investors and raising the round. As Naval Ravikant, a co-founder of AngelList, aptly noted in a recent interview on This Week in Startups with Jason Calacanis (at the 17:55 mark): “Convertible notes have made variable pricing possible.” Paul Graham reached the same conclusion in his post, “High Resolution Fundraising”:

The reason startups have been using more convertible notes in angel rounds is that they make deals close faster. By making it easier for startups to give different prices to different investors, they help them break the sort of deadlock that happens when investors all wait to see who else is going to invest.

Naval and Paul are referring to the conversion valuation cap (or the “cap”), which I will discuss in detail in part 2 of this series; for now, suffice it to say that the cap is designed to protect the investors by putting a ceiling on the conversion price of the note and thereby permitting investors to share in any significant increase in the value of the startup subsequent to their investment. If, for example, the cap were $5 million and the pre-money valuation in the Series A round were $10 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock at an effective price of $5 million or one-half of the price paid by the Series A investors.

Accordingly, the cap is akin to a valuation in a priced round (i.e., if the startup were issuing shares of common or preferred stock). But the beauty of the cap is that it is not a valuation for tax purposes, which is why different investors may get different caps, unlike in a priced round (unless there were subsequent closing sufficiently far enough apart to justify different valuations). As Paul says in his post above:

The reason convertible notes allow more flexibility in price is that valuation caps aren’t actual valuations, and notes are cheap and easy to do. So you can do high-resolution fundraising: if you wanted you could have a separate note with a different cap for each investor.

Why Do Sophisticated Investors Push for Shares of Preferred Stock Instead of Convertible Notes?

We’ve already covered one of the principal reasons: preferred stockholders are typically granted control rights, including a board seat and certain veto rights. They are also typically granted certain additional economic rights (like Series A investors), such as pro-rata rights and a liquidation preference. In fact, in the Fenwick Survey, 9% of the preferred stock seed financings included a participating preferred liquidation preference (which is not founder friendly).

Other reasons have been articulated by a number of high-profile investors (including Fred Wilson, Mark Suster, Manu Kumar and Seth Levine), the most significant of which can be summarized as follows:

1) There are now stripped-down, preferred stock financing documents (like “Series Seed” and other standardized forms) that make a priced round just as fast and cheap as issuing convertible notes.

2) The interests of the founders and the investors are “misaligned” if the investors are issued convertible notes that are not capped. This is because it’s in the founders’ interest to maximize the company’s valuation in the Series A round, and it’s in the noteholders’ interest to minimize it. Investors are thus “penalized” for helping a startup get a higher valuation as a result of their introductions, domain expertise, etc.

3) Obtaining a fair valuation may be tricky for unsophisticated investors, but not for sophisticated ones. As Fred Wilson argues: “I can negotiate a fair price with an entrepreneur in five minutes…”

4) Noteholders must wait for the date of conversion to start the clock running for long term capital gains treatment; with shares of preferred stock, the clock starts running immediately.

Are the Series Seed and Other Standardized Forms Really as Fast and Cheap as Convertible Notes?

The Series Seed and other standardized forms have solved a huge problem: how to get shares of preferred stock into the hands of investors in a seed investment without having to draft and negotiate a full-blown set of Series A documents, with all the bells and whistles (and associated legal fees of $50,000+).

However, to say that using these forms makes a preferred stock financing as fast and cheap as a convertible note financing is a bit misleading because we are talking about non-negotiable, fill-in-the-blank forms. Obviously, any transaction will be fast and cheap if the parties utilize fill-in-the-blank forms, without any back-and-forth negotiation.

Indeed, as I have previously discussed, the fundamental problem with these standardized forms is this one-size-fits-all approach. Every financing is different, and the structure and terms are based on a number of different factors, including (i) the size of the investment; (ii) whether the startup is “hot” (and there’s a competitive environment); (iii) who the investors are; (iv) current market conditions, etc.

Simply put, it may not be in the founders’ interest to utilize these forms and issue shares of preferred stock for a relatively small investment or if the founders have strong negotiating leverage (as recently demonstrated by $2.35 million convertible note seed financing by HealthTap) — particularly because these forms require the founders to grant certain control rights (and additional economic rights) to the investors, as discussed above. Nor does the issuance of preferred stock allow for the extraordinary flexibility that the issuance of convertible notes permits (also discussed above).

As Naval Ravikant profoundly pointed out in his recent interview with Jason Calacanis (at the 19:19 mark):

Venture capital used to be the bundling of advice, control and money. And now people have come along, like Y Combinator and TechStars and AngelPad and so on, to say ‘we’re the advice’; and then people have come in, like Yuri Milner at Start Fund, and say “we’re money – we just want to give you money” and the control provision has gone away. So you’re starting to see the whole ecosystem become unbundled.