Convertible Notes Are Debt That Hopes Never to Be Repaid

The Structure

a convertible note is a loan to a company that is expected to be converted into equity in the next priced financing rather than being repaid in cash

It has the characteristics of debt: a principal amount an interest rate and a maturity date. It also carries conversion terms usually a valuation limit a discount or both

Accrued interest is usually converted into equity along with the principal rather than paid out making the interest an increase in equity rather than a cash cost. That detail alone is responsible for most of the founders' mistakes about the instrument and deserves its own section below

Why Debt at All

Debt characteristics do three things and each is a transfer of something from the founder to the investor

They establish seniority. In a liquidation bondholders are creditors and rank ahead of all classes of stock including preferred shares. In a ruling that returns something that order decides who receives it

They create a deadline. The expiration date forces the question of a priced round rather than allowing an indefinite delay

And they provide leverage. A note approaching maturity with no financing in sight gives the investor a true negotiating position since the alternative is a repayment demand that the company cannot meet

What the Interest Actually Costs

The interest rate on a convertible note seems like the cheapest term on the document. Six or eight percent on money that will never be repaid in cash seems like an afterthought along with a valuation cap

It is not because the interest is settled in the cheapest shares that the company ever issues

Work with an illustrative note.One million dollars at six percent simple interest converting it twenty-two months later.The accumulated interest is one hundred and ten thousand dollars so one million one hundred and ten thousand dollars are converted

Suppose the limit is eight million dollars versus ten million fully diluted shares giving a conversion price of eighty cents and that the round price is two dollars per share. The note converts to 1,387,500 shares. With the principal alone it would have become 1,250,000. The interests purchased an additional 137,500 shares

At the round price these shares are worth two hundred and seventy-five thousand dollars. The company recorded a liability of one hundred and ten thousand and settled it with shares worth two and a half times as much

That relationship is more exact than approximate and goes in the opposite direction for the founder. The better the company does the higher the round price the greater the increase and the more the coupon will cost. A note that is converted at a five-fold increase converts a rate of six percent into thirty percent. The interest on a convertible note is the only expense that a company incurs and that becomes more expensive as the company is successful

In terms of ownership the figure above is 1.21 percent of the post-conversion company handed over for a term that no one negotiated

What Happens at Maturity

Demanding repayment from an early stage company is usually futile as the money has been spent on salaries and cannot be recovered from them. What actually happens is a renegotiation and the bondholder negotiates from the position of holding an overdue obligation

Extension is rarely free. The price is usually a lower limit a longer discount or a new ticket stacked on top of the old one each of which is agreed upon at a time when the founder has the least room to argue

The Maturity Mismatch

The scenario that founders must model before signing is not the default. It's arithmetic

An enlightened company raises one and a half million dollars for a ticket and burns one hundred and twenty-five thousand a month. That's exactly twelve months of runway. Eighteen months are missing from the milestone that would justify a priced round

A financing process takes approximately five months from first meeting to money in the bank. Therefore the raise must begin in month seven before the milestone exists and the note must survive at least until month seventeen for the conversion to occur as designed

A twelve-month expiration in that company leaves zero months of inactivity. It matures at the exact moment the bank account is emptied which is the worst possible time to be renegotiating something

The rule that follows is simple and rarely applied. The maturity must exceed the track that buys the note itself plus the time it takes for an increase. A note whose maturity is shorter has not created a deadline it has scheduled a crisis

Seniority, and What It Buys in a Failure

Antiquity is the term most often considered theoretical and is the one that produces the crudest arithmetic

Take the same one million dollar bill with its one hundred and ten thousand accrued interest along with four million dollars of Series A preferred. The company goes bankrupt and its assets are sold for one million two hundred thousand dollars approximately twenty-four percent of the five million dollars invested

The holder of the notes is compensated with interest for a bankruptcy that returned a quarter of his capital. The Series A investor who contributed four times as much and made the same bet on the same company receives two and a quarter cents

Nothing in that division reflects who supported the company the most or earlier. It reflects a clause. The person who wrote a smaller check as debt is a creditor and creditors get paid before owners

Conversion Terms and the Threshold That Triggers Them

The cap and discount work as in any convertible instrument: the note converts at the lower of the capped valuation or the discounted round price producing more shares per dollar than new investors receive

The provision worth reading carefully is the trigger. The conversion is usually triggered by a qualified financing defined as a capital round above a set size typically one to five million dollars

A round below that threshold does not convert the grade. The company has raised money has been diluted and still has an obligation due or past due because the round was $300,000 short of a figure written eighteen months earlier

Companies raise amounts that fall short particularly when a round is assembled from several smaller commitments. The threshold is negotiable is rarely negotiated and is the cheapest protection a founder can get in the entire document

Change of Control Before Any Round

If the company is acquired before any quoted round the note cannot be converted into a round that never occurred so the document specifies an alternative. Typically the holder chooses between repayment at a multiple of the principal and conversion at the cap

The illustrative note continues: one million dollars a cap of eight million dollars and a change of control multiple of two times. Converting to the limit gives 12.5 percent of the company

The price of the crossover amounts to exactly sixteen million dollars where 12.5 percent of the sale is equal to double the capital. Below it the multiple links and the sale price are irrelevant to the holder of the ticket. Above it the limit joins and the multiple is irrelevant

Letting the multiple rule low results is the point of negotiating it. A founder who accepts a triple multiple has agreed in a modest sale to pay three million dollars of the profits before any shareholder receives anything

The Accumulation Risk

The notes accumulate and unlike a simple agreement they accumulate with interest on each layer

An illustrative company builds three bridges waiting for a round that has not yet arrived: five hundred thousand at eight percent against a cap of six million pending payment for twenty-four months; seven hundred and fifty thousand at eight percent against a cap of nine million pending payment for eighteen months; and one million at six percent against a cap of twelve million pending for twelve months

The accrued interest amounts to two hundred and thirty thousand dollars on two and a quarter million principal 10.22 percent of the money raised added to the conversion amount instead of paid

Converting at their respective ceilings the three get 9.67 9.33 and 8.83 percent. Together they have committed 27.83 percent of the company for two and a quarter million dollars in bridge money

New investors examine that stack carefully because it determines how much of their investment effectively funds the conversion of previous instruments rather than the deal. A large complex overhang can make a round materially more difficult to raise which is a cost that appears long after the notes have been signed and is charged to the person who signed them

Who Holds the Note Decides Whether It Can Be Fixed

A note is a contract and it is very likely that the contract will need to be modified since extension is the most common outcome upon expiration. Whether that amendment is feasible or not depends on a term that almost no one reads at the time of signing: who has to agree

Modifications normally require the consent of the holders of a majority in interest that is holders of more than half of the outstanding principal instead of more than half of the holders

Let's go back to the two and a quarter million dollars in bridge bills. Most of the interest is greater than one million one hundred and twenty-five thousand dollars

If three investors maintain one million two hundred thousand between them the extension is three conversations and can be done in one week

If the same money was raised from twenty angels at one hundred and twelve thousand five hundred each the company needs eleven of them because ten is exactly half and half is not a majority. Eleven different people have to read a document understand it and sign it during the month in which the company is running out of cash

Anyone who has changed their email address lost interest or simply stopped responding is considered a reject. A dispersed base of noteholders does not produce hostile investors but absent ones and absence and hostility have identical effects on the consent threshold

Building a bridge for many small homeowners is easier at the time and is the version that cannot be repaired later

Notes Versus SAFEs

Simple agreements displaced promissory notes in much of the early-stage market because they are cheaper to document bear no interest and eliminate maturity pressure

Notes persist where investors want protection: in subsequent or larger bridge financings in markets outside the United States where the simpler instrument is less established and where the investor specifically wants seniority and a target date

The pattern is that notes reappear when capital is scarce and investors have leverage and simpler instruments dominate when capital is abundant. The choice of instrument is a reasonable reading of the market conditions at the time of signing

The Bottom Line

Convertible notes are loans that convert to equity in the next round of pricing using a cap and discount to price the initial risk. The characteristics of the debt are not incidental: seniority recovered the bondholder one hundred cents in a bankruptcy that paid two and a quarter preferreds and the interest is settled in the cheapest shares the company will ever issue so a six percent coupon converted with a two-and-a-half times increase costs fifteen percent in price terms.round.Set a maturity longer than the term plus the time it takes to raise check the qualified financing threshold and count the accumulated surplus before signing the next bridge because the next investor will certainly do so