At VentureSouth, we often find ourselves fielding pitches from entrepreneurs attempting to raise capital via convertible notes. And almost as frequently, we find ourselves pushing back against the convertible note structure in favor of a priced equity round.
Since many founders now seem to default to convertible notes for their first round of funding, we want to lay out our rationale for why we think that structure is usually not the best approach – for entrepreneurs or investors.
For new founders or investors who may be unfamiliar with the details of convertible notes, you can start here with our quick primer on the important terms you need to know. Then come back for our three part series on the reasons we typically steer clear of convertible notes.
Part 1 covers the primary downside rationale for founders, Part 2 outlines our key objections from the point of view of investors, and Part 3 uncovers some of the hidden costs of convertible notes that are rarely acknowledged.
Convertible Note Downsides for Founders
Misalignment
Perhaps the most problematic aspect of using convertible notes is the misalignment it creates between entrepreneurs and their investors. Whereas equity investors are on the same side of the table as founders when it comes time to raise the next round of funding (and will help advocate for the highest reasonable valuation), noteholders are actually on the other side of that equation in that they benefit more from a lower valuation (since their debt will convert to equity based on the price of the next round – and the lower the price, the more equity they will own upon conversion). While entrepreneurs might like to think that investors would be just as supportive in either case, incentives matter and the misalignment of interests can create problematic friction at just the wrong time when trying to raise the next round.
Avoiding valuation
Of course the primary reason most founders pursue convertible notes is to avoid the presumably difficult exercise of agreeing to a valuation for the company. While it is true that early-stage valuations are more art than science, there are plenty of well-established methods and rules of thumb for establishing an appropriate valuation. Unfortunately, since the ultimate ownership stake for the convertible note round is unknown at the time of investment, entrepreneurs are often unpleasantly surprised when they finally see the full impact of the dilution from the accrued interest and conversion discount associated with the notes.
Additionally, an unwillingness to engage in valuation discussions and debate may signal to an investor that the entrepreneur hasn’t done his or her homework on what to expect when fundraising, which can undermine the credibility needed to secure an investment. Lastly, the valuation exercise provides founders with an opportunity to work through a potentially challenging discussion with the investor – which can provide invaluable insight into how well the two parties may be able to work together (or not) in navigating the inevitable future challenges all startups face.
Growing liability
Entrepreneurs often fail to recognize the crippling impact an unconverted note can have on the company’s balance sheet. If the note doesn’t convert in a relatively short time frame, the continuously growing liability (from the accruing interest) can add up to a significant number that makes the balance sheet a significant barrier to future fundraising efforts. And of course new equity investors will anticipate the dilutive impact of the converting notes by adjusting their valuation offer downward accordingly.
Hidden dilution
While the convertible notes continue to accrue interest, the future dilution to founders is accelerating as well. Remember that the principal and interest of the note will convert into the next round – at a discounted price – so the longer the note remains outstanding, the more shares investors will receive at conversion – and the further founders will be diluted. In our simple example, you can see that a $1,000,000 initial convertible note in this case turns into $1,375,000 worth of shares at conversion (because of the accrued interest and conversion discount).
Piers vs bridges
While a convertible note is intended to provide sufficient runway to reach a future funding event, too often the would-be “bridge” becomes a pier, leaving the company stranded between the accruing liability from the notes and their efforts to reach the “other side” with a new, fairly-priced equity round. If no conversion event appears on the horizon, the investors may decide to call their notes at maturity, pushing the company into default and ultimately taking over the assets with no recourse for equity holders like founders and employees.
Efficiency
Many entrepreneurs choose to raise money via convertible notes because they can often be issued faster and cheaper than a preferred equity round. While this is true to some extent, the advent of standardized equity round documents like Series Seed has mitigated these differences significantly. An experienced, reputable law firm that works with startups should be able to execute the equity documents at a reasonable price that is not significantly higher than the cost of convertible note documents. In the end, creating alignment between investors and founders will prove to be much less expensive than the incremental cost of issuing equity instead of a convertible note.
If you’re interested in hearing more from our soapbox, click here for Part 2 of our Case Against Convertible Notes.