It seems like a majority of pre-Series A deals are done with convertible debt these days and I’d like to point out a few reasons why this is a bad thing for entrepreneurs and investors alike.
Just to get definitions out of the way, we’re talking about the decision to raise funding for startups by either equity investment in stock of a company, or in a convertible debt instrument. Equity is pretty straightforward – invest money, get stock. Convertible notes, on the other hand are not widely known to those outside of startup investing. Convertible debt works like regular debt in that there’s a promissory note and an interest rate. The interest is rarely paid in cash for convertible notes though, and it’s usually rolled into equity when the note converts into equity. There are usually a few “triggers” for having the note convert to equity, but the most prominent one is that there is a “qualified financing round” which is usually around $1 million. The idea is that the professional investors at that stage know how to value the business and set the terms. The first early investors who invest will convert at the terms set by the VCs, but usually with a 20% discount in price to compensate for investing earlier. Convertible notes today also have a “valuation cap” which is equal to what the equity valuation would have been if the deal had been a stock transaction in the first place. So, when the qualified round causes the note to convert, it converts at the lower of the 20% discount or the valuation cap.
Reason 1: Convertible Notes do not qualify for Section 1202 QSBS Tax Breaks
Angel investors get a 100% capital gains tax break if they invest in equity in early stage companies that meet certain criteria such as being a C Corp., being under five years old, under five million in revenue and they hold the investment for five years. Convertible notes don’t qualify for this tax break, so if all things were equal, the investor makes 20% LESS on convertible note deals since they have to pay capital gains tax on the investment, whereas investors who invest in equity do not have to pay any tax at all.
Reason 2: Equity is cheaper than convertible debt
You may have heard that it’s cheaper, faster and easier to do a convertible note, but the fact is that convertible notes are going to end up costing the company approximately 25% MORE than an equity deal. The reason for this is that when the note converts, then it converts into EQUITY. That means that the company pays twice for the legal: once to do the note and another time to do the equity. So if a convertible note cost $2500 in legal fees and the equity deal cost $10,000, then the convertible note all-in is going to cost the company $12,500. Why not just do it right in the first place and put all that money to work for the company?
Reason 3) 80% of Angel Investors Prefer Equity
If you’re selling something to a customer, wouldn’t you want to sell them what they want and not some more expensive and inferior product? The American Angel Survey shows that investors prefer equity and I suspect that if the remaining 20% of angels read this blog, they’d prefer equity too.
Reason 4) You can lose your company if you default on a convertible note
When you take out the note you’re confident that you’ll have a qualifying follow-on round within 18 months, but many times it takes longer and the note comes due and payable and you’ve already spent the money and can’t raise any more. You’re in default and investors can take your company from you. Most investors don’t want to do that, but why go through the heartburn and stress of facing the potential loss?
Reason 5) Investors have to pay tax on interest they earned but never got
As interest accrues on convertible notes, interest is due. Investors need to pay tax on those notes, even though they didn’t actually get the interest in cash. So, if someone invests $100,000 in an 8% convertible note, they have to pay $2640 in cash to the IRS on that income. Nobody likes paying taxes on money they never got and also, BTW, there is no tax due for equity investments.
Reason 6) You have to come up with a valuation for convertible notes just like equity.
Many people think that using convertible notes lets them “kick the valuation can down the road.” Nothing could be farther from the truth. Every convertible note has a provision called the “valuation cap.” The formula for calculating the valuation cap is as follows:
This means that when someone invests in a convertible note, they should never have to pay more than what the company is worth today. If the valuation cap were higher than equity valuation, that would mean that note investors would have to pay more than the value of the company. Just because it may convert at a higher valuation some time in the future does not mitigate the risks that the early stage investor has today. In fact, the only way that the higher valuation comes about in the future is that the angel investor puts in the capital early, when risk is highest, so it doesn’t make sense that they should pay more than what the company is worth.
Many companies get confused about this. One company told us that the valuation would be $5 million, but it would be $7 million valuation cap “because it’s going to convert at $12 million some day.” It’s crazy to think that somehow using a convertible note makes a company worth $2 million more than one that uses equity. This kind of thinking makes no sense and hurts the startup community.
Putting valuations on early stage companies is something that is done every day and there’s no magic to it. Seed Funds and Angel Groups have well established valuation methodologies that work well on pre-revenue companies.
Reason 8) Entrepreneurs get diluted with convertible notes
Entrepreneurs should be cautious about the cumulative dilution that paying interest which will be rolled into equity will create. The longer the note goes on, the more startups will be diluted with the interest that they have to pay in the form of equity. It would be better to preserve that equity for future growth. Founders who chose equity over convertible debt don’t have to worry about interest accumulating and diluting their shares.
Reason 9) Equity creates better alignment between investors and founders
When convertible debt is used, there is a misalignment between investors and entrepreneurs. Founders want to use high valuation caps or worse, no valuation caps, and prolong the amount of time before conversion, so that investors get the short end of the stick. Some founders openly state that they want to use convertible debt to preserve their equity. Those are founders that every investor should avoid – not because they want to build a strategy that preserves equity, but that they want to create unfair terms that preserve equity at the expense of investors.
Reason 10) Equity deals have all the terms defined
With a convertible debt deal, the conversion price is negotiated, but all the other terms which are extremely important to the relationship between the founders and investors are left open. This represents a risk to investors and also leaves many matters unsettled. One example is that there are usually terms about board representation which are not found in convertible notes. Investors in early stage companies can offer much more to companies than just a check if they can serve on boards and help move the company along. While there’s nothing to say that companies with convertible notes can’t have boards, in fact many don’t and that’s bad for both investors and entrepreneurs.
With all that being said against convertible notes, they can still be useful for the FFF rounds with friends and family who don’t know how to value a deal and who are investing primarily to support the entrepreneur. Convertible notes can be better than some of the amateurish deals that get put together for early family investors who are often non-accredited that can make follow-on investments difficult or even impossible for the company, thus limiting its chances for success. Visit www.rockiesventureclub.org to learn more.