Startup Convertible Notes – Enough Already
I have been thinking a lot about convertible notes recently. They may be a primary vehicle to fund early stage startups but they are less straightforward than they appear and contain nasty traps for the unwary – both founders and investors.
Bottom line – notes are not what they seem and can harm a startup's longer term fund raising goals. So Caveat Emptor. And, if you are the Emptor, maybe you should advocate for startups to issue priced equity (i.e. preferred stock) more often. And do so both in your personal interests and frankly in your investee's interests too.
In this post I will cover the big picture of the anti note thesis then cover more specific things to look out for as an investor and then things to be mindful of as a founder.
1. The Big Picture
Standardized? In your dreams! This is what got me started: I have seen a slew of convertible note term sheets recently both ones I have been looking at on my own account and ones I have been asked opinions on by other angel investors. As I compared more and more I was stuck by something I didn’t expect – but shouldn’t have been surprised by really. Namely how very different they all are. Which is odd because “we” the investors (well, this investor anyway) usually say that notes might have disadvantages but “at least they are easy, quick and standardized and hence cheap relative to a priced round.” Mmmm - I take that back!
The more I looked the more I realized each and every note has its own quirks. OK - so I did actually read notes before now. But still, when you review a lot of them back to back, it’s more obvious: tweaks on the various scenarios at note expiry (in some cases unclear and ambiguous); on follow on rights or most favored nation (MFN) provisions (although not enough have either of those); interest rates; and also around the fundamental issue of pricing via the cap – so caps, no caps, varieties of discount and indeed maybe a scaling discount.
Besides these complexities (memo to self - note terms need very careful attention) notes have more fundamental problems. Smart and active investors like Mark Suster and Brian Cohen have written about (see Marks’s BLOG) and talked about (see Brian on SCREEN) the delusions and risks that surround convertible notes. Most obvious is that investors in a note have minimal rights. Duh - It is a debt instrument after all so not too surprising but can still be shocking when the reality hits. Less obvious that on conversion you do not get adequately compensated for the risk you took. (The most extreme is the case with a no cap note when the business takes off and the Qualified Financing is struck at a much higher pre-money than the investor thought going in.)
Notes can also have an adverse impact on future financings too. As Nnamdi Okike from 645 Ventures notes seed stage companies need to aim for a "competitive Series A" given the low (and declining) conversion rate from A to follow on B rounds. As Nnamdi points out an obstacle to that competitive A can include an overhang of too many notes or a over priced seed round (which would include, in my book, a note with an overly aggressive cap).
Another issue is the fact that notes typically don't impose any governance framework on founders. Good for them in a sense that they maintain full freedom of action but also bad because it can a) mean there is no accountability, no one holding the founder's feet to the fire and also b) no period of "training wheels" with say a three person Board before they get hit with a full on Board that will inevitably accompany a larger priced round. As Brian Cohen points out this is about being professional - and professional early stage investors want to see and be engaged with professional investees. Good governance is a key part of that.
Now some more specific things to watch for, first on the investor side. then the founder side:
2. Look out below - Investors
Vincent Jacobs at Kima Ventures lists seven issues that can arise to confound investors and thoughtfully provides steps that note investors can try and take to remove or mitigate them. The concerns Vincent dissects are set out below … investors please do READ his post because he offers suggested remedies in each case:
1) Receiving worse terms than other investors
2) Converting into preferred stock without the desired rights
3) Not receiving the same rights as other investors when the debt converts
4) Converting into common stock instead of preferred stock
5) Having the loan repaid despite a successful exit
6) Having the loan repaid despite the company doing well
7) Having other investors force an unfavorable decision
On the subject of not receiving the same rights as other investors, I would add look out for for side notes. (Or rather ask for them, the point is you can't "see" them.) Coming from a career in the public markets my going in assumption in startupland was that my term sheet is your term sheet is her term sheet. i.e. all investors in a note have the same terms good or bad. The point being that in the public markets investor rights are simple and highly transparent. Not so, I discovered in private markets.
One thing I have learnt to ask founders is: "Have you agreed any "side notes". In other words made specific contractual commitments to one investor that are not given to, or made transparent to, other investors. A common example would be giving one specific investor some form of follow on investment right into the next round. There is nothing "wrong" (legally) with this although the transparency/Reg FD bone in my body doesn't really like it - and I do like to know what others are getting that I am not.
3. Look out below - Entrepreneurs
Coming from entrepreneur's direction James Geshwiler MD at CommonAngels Ventures has offered seven surprises on convertible notes that founders should know about. (Am guessing the number seven on both sides of the table here is just a coincidence!) Again founders read James's post for the full details but the seven are things that could hit you unawares or could deny you benefits that might accrue from a priced round in his view are:
1) Little Value Add from Investors
2) Reduced Incentives to Help
3) More Preference
4) Less Discipline
5) Two Words: “Full Ratchet”
6) Deceptive Dilution
7) Lost Allies