If you missed Part 1 of our Case Against Convertible Notes, follow the link to read about the primary downsides for founders. In this post, we’ll tackle our key objections from our point of view as investors.
Convertible Note Downsides for Investors
While the discount on a convertible note provides some additional value for the early investors, it rarely provides adequate compensation for the disproportionate risk the noteholders took at the time of their investment. The standard discount on a convertible note is usually around 20%, but in most cases the actual value of the company at the time of the note investment is likely 40%-50% lower than the valuation at the time of the next equity round – so the investors are almost always overpaying. A valuation cap can (and should) be added to the note to mitigate this risk for investors, but in most cases the cap is still higher than the appropriate valuation at the time of investment. And since establishing a valuation cap requires a price negotiation anyway (which convertible notes are designed to avoid), it usually makes more sense to go ahead and do the hard work of negotiating a fair price for the equity at the time of the original investment, rather than punting that determination to some unknown point in the future.
Investors should avoid investing in convertible notes without valuation caps. If the entrepreneurs are successful in deploying investor capital to build significant momentum, the price of the next round is likely to be much higher than the investors anticipated, leading to a much higher conversion price (and lower equity stake) than they reasonably expected. Essentially, the company has taken investors money at the highest risk stage of the business and used that capital to drive up the price the investors pay to own a piece of the business they helped accelerate!
Tax on interest
Another key issue for investors are the tax consequences of convertible notes. When the accruing interest on a convertible note converts into equity, investors are required to pay income tax on the interest earned – even though they are not receiving cash from the company.
Capital gains and QSBS treatment
Additionally, the capital gains clock for investors doesn’t start at the time of the convertible note investment, but rather at the time of conversion. This creates a scenario in which a company could take advantage of an early exit opportunity, say 18 months after raising a convertible note, but if the noteholders converted 9 months after the initial investment, they would be subject to ordinary income tax rather than the lower capital gains rate which would apply for an equity investment held for more than one year. Perhaps even more importantly, the five year clock for 100% capital gains exclusion under the Section 1202 Qualified Small Business Stock provisions only starts at conversion, not at the time of the original convertible note investment.
Testing the relationship
As we alluded to in Part 1 of this series (in the section on avoiding valuation discussions), convertible notes circumvent an opportunity for investors and entrepreneurs to test the relationship. If the two parties can’t have a productive, respectful conversation about the subjective and challenging topic of valuation, it may signal potential strain in the working relationship when faced with the inevitable, inherent challenges and conflicts that arise in all startup companies.
Before we get to Part 3 of this series, we do want to acknowledge that there are a limited number of situations where we think convertible notes are appropriate.
Namely, we support convertible notes only when they provide a true “bridge” to a near-term conversion or acquisition event. These notes should represent a relatively limited amount of capital (typically less than $500K) that is intended to carry the company to the conversion or acquisition event within three to six months.
Now, on to Part 3 of our Case Against Convertible Notes