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Startups & Venture Capital

Why Startups Use Convertible Notes

Published on
20 Mar

For the past 10 years or so, founders of early-stage startups have been increasingly turning to convertible notes and convertible equity instruments to structure investment rounds, particularly for their first capital raise. While some in the angel investment community have argued that it would be best if founders did fewer convertible note rounds and more equity deals, it’s important to consider why the convertible note structure has made such a big splash in early-stage financing world in the first place. What are the primary benefits for founders and their investors to opt for a convertible note offering over a stock offering? In future posts, we will consider the key deal terms to consider for your convertible note offering but first let’s look at the key benefits of the convertible note structure to determine if it is right for your company.  

If you’re a founder, you might be thinking “what’s wrong with simply selling, for example, 10% of my company to an investor in exchange for $100,000 to get us off the ground?” This raises the first issue that convertible notes are intended to solve, and that is the problem of valuation. Let’s suppose your company is pre-revenue, still working on the beta version of its product, or perhaps looking for that first enterprise customer. Does it make sense to slap a $1,000,000 post-money valuation on the company at this stage? Perhaps, but what if you end up getting a lot of traction with that $100,000 and raise a Series A round at a $10 million valuation 2 years later? Your first investor is going to be ecstatic, but you’re going to have some serious seller’s remorse for giving away such a large chunk of your company for what you now realize was an extremely low valuation.

The primary advantage of a convertible note is that it allows founders and investors to postpone the valuation discussion to another day. Convertible notes convert into equity based on the valuation of the company’s next equity financing round. So, using our example above, instead of the investor getting 10% of the company in exchange for the $100,000, the investor would convert into the round that valued the company at $10 million at, for example, a 20% discount. From the founder’s perspective, the company was able to use the $100,000 to gain the proper traction to justify a higher valuation and avoided the dilution from selling equity at a $1 million valuation. Meanwhile, the convertible note investor is satisfied because he is being compensated for taking the extra risk of coming in early with a discounted purchase price in the new round. While other investors are willing to pay $1.00/share for the company’s stock, the investor is being treated as purchasing that same stock for $.80/share.

The second reason traditionally used to justify convertible notes is simplicity. Returning to our example where the founders want to sell a 10% equity interest in their company, what are the terms of this initial $100,000 investment? Is the company selling common shares or preferred shares? If the company sells, will the sale proceeds first go to return the investor’s money or will the founders and the investor split all proceeds 90/10? What happens if the company raises capital on better terms in the future? Will the investor receive those better terms or have an opportunity to participate in the new offering to avoid dilution?

Issuing a convertible note in lieu of company stock once again allows the founders and the investor to postpone these decisions until the company’s next equity financing round. The convertible note investor will simply convert into the class of shares offered in the next equity financing and generally receive those same rights (with certain exceptions). Given this simplicity, a convertible note offering is generally cheaper than putting together an equity financing round. With that said, however, it is important to remember that both types of offerings involve the issuance of a security, and you will need to consult an attorney in both cases to ensure compliance with federal and state securities laws. In addition, the angel financing community has matured to the point where there are generally agreed upon terms for first-money convertible note offerings and first-money equity offerings, which reduces the negotiating complexity for both types. Therefore, while it is generally true that convertible note offerings are more simple to put together, the costs are not always that distinct from equity offerings, and outside factors – like who your investors are and the amount of negotiating leverage they have – will play a significant role in the overall complexity of the project.  

There’s no doubt that convertible notes have been a nice addition to the early-stage financing landscape, particularly for founders since it allows them to raise capital efficiently and without granting the rights typically reserved for preferred stock investors. Although convertible notes postpone discussions regarding company valuation and preferred stockholder rights, these decisions must be made at some point. Therefore, convertible notes are best viewed as a bridge to get the company in the best possible position for a larger round of equity financing.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.