Convertible Notes, When to Use Them, How to Structure Them and Why Investors Hate Them

May 12, 2008 – 10:18 pm by RM Crill

Ahhhh, convertible notes. So easy to use, such a comfortable way to avoid the “v” discussion (valuation), so simple to understand. But why aren’t they universally loved?

Let’s think about convertible notes in two classes – standard and “true convertibles”. Standard notes are used more often than they should. They remain in effect for long periods (over nine months) and are issued before the triggering financing event is easily foreseen.

These standard notes are quite often an inappropriate use of a convertible note. Sure, they avoid the valuation discussion but leave investors with poor value given the risk they’re asked to take.

Investors set out to achieve about a 10x return in most of their early-stage deals. It takes about four years to get that return so about 2x per year is required (I’m allowing for some compounding) with higher returns in the early years. First-money in a start-up needs better than a 250% return in that first year to make this work. Well, I suppose you could offer a 250% per annum discount on a convertible note but something tells me the math will be problematic. Investors who buy convertible notes as first-money in start-ups without a clear plan (e.g. company is in diligence with the Series A investors) to trigger the conversion are taking all the risk an equity investor would take but without the reward.

True convertibles are different. This is a convertible note issued when the note will likely convert in under nine months and they’re particularly appropriate when the issuer needs to extend cash-flow negative operations for a few months while diligence is concluded or while the business completes a transition to profitability.

As to structure, there only a few terms that really matter.

  • Discount or Warrants. For the unfamiliar, this is the key consideration offered with a note. The choices are a discount that allows (well, compels, actually) to convert his note into the upcoming security at a percentage of price paid by those who buy the security directly. Warrants represent the right to buy future shares at a fixed price and, in the case of convertible notes, are typically offered as a percentage (called “coverage”) of the note. Ten percent warrant coverage would typically mean that the note holder receives one warrant for every ten dollars loaned on the note.The advantages of discounts include lower taxes for the note holder (long term capital gains since warrant holder seldom (or seldom should) exercise their warrants within 12 months of an exit) and more voting, pro-rata, and other rights (warrants don’t provide the rights of the underlying security until exercised).
    The advantage of discounts to the company is a somewhat simplified cap table. A disadvantage of warrants is subtle. Since all issued warrants will also reduce the per-share price of future rounds (i.e. they are included in the count of fully-diluted shares), the warrants have to be purchased but there is no positive adjustment for their purchase price. Hence investors treat warrants as more costly (they have to be bought); they have all the negative impact on the cap table with no offset for their eventual positive impact. The advantages of warrants include… well, there are none. In fact, discounts are so much more favorable to investors (largely due to taxes), that a company should be able to offer a discount rate that is about 80% of the warrant coverage it would offer; a structure benefiting both sides of the transaction. That is to say at a 24% discount should be preferred by investors to 30% warrant coverage given the tax and other benefits and the lower discount is certainly preferable to the issuer.
  • Linear Discounts. A per-annum discount of 30% – 50% is reasonable in most cases. But how that is structured matters a good deal. It’s a mistake to simply award a set discount to all who invest regardless of when they do so. For the company, it makes raising money harder as investors are not incentivized to invest early – a smart investor will be the last note purchaser. Discounts can either be earned linearly (e.g. 3% per month) or non-linearly (e.g. a cumulative discount of 10% in the first month, 7% in the second, 5% in the third, and 3% each month thereafter). Non-linear discount schedules incentivize early investment more heavily.
  • Trigger for Mandatory Conversions. This is largely misunderstood. The trigger is the amount of capital raised in the pending equity financing that will mandatorily convert the debt. Too often, companies assume that it should approximate the capital requirements of that round. This is wrong. The trigger should represent an ample capital raise to eliminate the potential of the company dragging the convertible note holders into a non-market based financing round. If the trigger is set too low, the company could close on a questionable and company-friendly round to the detriment of the note holders. The trigger should be set at a minimum of about $250,000 or two times the amount of the convertible note, whichever is higher, to avoid this.
  • Maturity. Convertible notes should mature in one year or less.
  • Actions at Maturity. Too many notes are simply written with a balloon payment upon maturity. This is an invitation for a later negotiation. If the note isn’t mandatorily converted prior to maturity, the company has likely stumbled and is unable to repay the notes. The note holders will meet with the business that they now effectively own and negotiate next steps. Better to offer an alternative that has some potential for viability. We favor giving the company the choice of either making the balloon payment or increasing the interest rate to the usury limit and repaying over time.
  • Conversion Prices. Investors should have two different conversion prices: one for a change of control while the note is outstanding (this should be set at the market price when the note is issued) and one for an optional conversion upon maturity (this would be a bargain price as the company failed to cause a mandatory conversion).

There are other factors like interest rates (typically 6 or 8%) and secured interest (companies should offer first position on the assets of the company and investors shouldn’t think that’s going to give them much) and others, but they’re either well-understood and agreed-to or just don’t matter.

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