Convertible Notes can be a useful structure for raising early-stage capital, either as initial seed capital or in between equity financings. But how do you know whether you should issue convertible notes or shares of stock?
1. It’s what your investors want, and that’s a pretty good reason to structure your financing as the sale and purchase of convertible notes. Some investors like the convertible note structure, some don’t. The main rationale I have heard over the years is that investors do not want to purchase equity at one price and then have the VCs come in later at a lower price per share. If the investors are purchasing common shares, this makes perfect sense. But with the ability to do preferred stock financings so quickly and inexpensively, I’m not sure that this rationale continues to hold up when the investors can purchase preferred stock and negotiate price-based anti-dilution provisions.
2. You can’t agree with the investors on valuation, and the convertible note structure lets you close the seed round and defer the negotiation on valuation to a later date. If you can agree on the valuation of the company, you can normally get to agreement on the other terms as well (for example, what kind of liquidation preference), so there is no reason not to do an equity capital raise. But when you cannot agree on valuation, the convertible note structure is the way to bridge the gap.
3. You don’t have critical mass on your funding yet to set terms, so the convertible note structure let’s you start to raise funds until you can reach that critical mass and set the equity terms. While the percentage can vary, once you can get about ½ of the funds in the financing committed, it makes sense to set the terms and close and then try to herd in the rest of the cats on those terms.
If one of these conditions is not present, be careful about raising funds as convertible debt. It is debt, and so you have to be mindful that there will be a maturity date when the notes will come due and payable. If your company does not have the ability to repay the debt (and it won’t!—convertible debt is supposed to be converted into equity, not repaid), then what will happen at maturity? If you have not pre-negotiated what will happen and provided for it in the convertible notes (such as conversion to equity at a modest valuation), then the investors will have the negotiating leverage when the notes come due and you have to settle on the notes with your investors.
Let me hammer home this last point, convertible debt is supposed to be converted, not repaid. The best way to think about convertible notes is that they are a pre-closing on your equity financing. Go in knowing that you will have to raise money in a “qualified financing” to convert the notes. If your investors start asking about collateral for the notes (and I’ve seen this happen), then be careful, they’re expecting to be repaid at maturity, and the overwhelming likelihood with a startup technology company is that it will not have the ability to repay the debt. In that case, it’s best to pre-negotiate what will happen if the maturity date rolls around and the company cannot repay the debt.
Image credit: CC by Gianni Sarti