What is a Convertible Note?
A convertible note is essentially short-term debt that converts into equity at the closing of a Series A round of financing. ((Scott Walker, Everything You Ever Wanted to Know About Convertible Note Seed Financing (But Were Afraid to Ask), TechCrunch (Apr. 7, 2012), http://techcrunch.com/2012/04/07/convertible-note-seed-financings/)) Essentially, an investor will loan a certain amount of money to a startup in return for a note with terms defining how the equity distribution will work. ((Id.)) Generally, the investor will loan money to the startup as its first round of funding in return for shares of preferred stock as part of the startup’s initial preferred stock financing based on the terms of the note. ((Id.)) This allows the startup to receive money at an early phase when it is likely strapped for cash. In return for the short-term debt the investor gets preferred stock, which usually will contain some set of preferential rights (e.g., liquidation preference, right of first refusal, anti-dilution protection, etc.). ((See id.))
Why Are Convertible Notes Issued?
Some people may wonder why convertible notes are issued instead of common stock. Usually, founders, friends, and family are all issued common stock when investing in startups. Unlike these investors though, most sophisticated investors will not accept common stock, and rather, will negotiate for preferred stock with preferential rights giving the investors increased downside protection. ((Bryan Springmeyer, Using Convertible Notes for Angel Investing, Springmeyer Reddy (Dec. 31, 2011), http://www.calstartuplawfirm.com/business-lawyer-blog/convertible-notes-vs-preferred-stock.php))
The issuance of common stock also creates three major problems. First, it is difficult for investors and founders to agree on the valuation of a startup and thus the percentage of ownership the investor will receive since there is no operating history of the business. ((See id.)) Because of this difficulty, founders risk dilution of their ownership of the company. Investors who generally ask for anti-dilution provisions will have less skin in the game than founders in terms of dilution of their equity. ((See id.)) Therefore, founders have a much larger risk when issuing common stock based on a speculative valuation of the company. ((See id.)) Second, there may be tax issues depending on the timing of the investment. ((Walker, supra note 1.)) Tax issues may arise if for example the founders issue themselves common stock at nominal value and investors pay substantially more for their shares of common stock around the same time. The IRS may impute a higher value to the shares of common stock issued to the founders and deem the excess amount over the original nominal purchase price a form of compensation. ((Id.)) If this were to happen the excess amount over the nominal purchase price would be taxed as ordinary income of the founders. ((Id.)) Unfortunately, if this were to occur when the startup and the founders are low on cash, the business could be in significant amount of trouble. Third, the issuance of common stock will cause potential problems for stock option grants because the underlying value of the shares of common stock will have been established. ((Id.)) The issuance of common stock to investors will lead to an increased strike price for the shares of stock. ((Id.)) This will be problematic because the goal of stock option grants is to price the options as low as possible so that the option recipients are incentivized to increase the value of the company and thus realize returns on their investment. A high strike price will weaken this incentive and undermine the goal of stock option grants because a high strike price will make it much harder for option recipients to increase the value of the company and realize the added value.
What Are the Advantages of Convertible Notes?
The main advantage of using a convertible note is that the issue of valuing stock is pushed back until the Series A round of financing when there are a lot more data points and thus it is much easier to value the startup. ((Carlos Eduardo Espinal, The Basics, Pros and Cons, Points to Consider, and the Modeling of Convertible Notes, Seedcamp (Mar. 16), http://www.seedcamp.com/resources/the-essentials-of-convertible-notes)) Using convertible notes solves the three problems posed by issuing stock to investors. ((Walker, supra note 1.)) Convertible notes are debt, and therefore do not need valuation of the startup. ((Id.)) Without the need for valuation of the startup there are no problems of dilution of founders’ equity stakes, no tax issues, and no stock option pricing issues. ((Id.))
Using convertible notes also reduces transaction costs. ((See id.)) By avoiding the need to value the company before a Series A round of financing, the startup and investors can save time and money by avoiding a speculative valuation of the company. ((See id.)) Convertible notes also benefit entrepreneurs by avoiding the granting of control rights to such investors and the increased flexibility of convertible notes. ((See id.)) Entrepreneurs can avoid the granting of board seats or veto right to these early investors which will allow the entrepreneur to better decide how she wants to run the company. ((See Walker, supra note 1.)) So the simplicity and cost savings of using convertible notes also add to the value of the short-term debt option and the benefits it provides for both entrepreneurs and their investors. ((See id.))
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