Startups: Convertible Notes Can Be a Value Trap

Photo by aldenjewell via Flickr

In the world of equity investing a value trap is a stock that has an attractive price to earnings ratio, or exceptional cash flow or a low price to book ratio or a combination of all three. When one or more of these benchmarks exists with a corporate stock, investors can be lulled into a false sense of confidence because the stock is perceived as a bargain acquisition.

Parallels with Convertible Notes

Entrepreneurs and angel investors alike should approach convertible notes, more appropriately known as bridge loans, with a healthy dose of skepticism. Bridge loans can have seriously negative consequences for the entrepreneur as well as the angel investor. Like the value trap of the equity investment universe, what both parties may deem attractive at first blush can often lead to unintended consequences, but before we get into the particulars, we should define convertible notes.

Definition of a Convertible Note

The convertible note is an investment vehicle used by angel investors to fund a startup business. It is essentially a loan agreement but unlike a typical loan, the terms of repayment include the right of the investor/lender to convert unpaid principal (and often accrued interest) into equity (stock). The trigger for this conversion is usually the appearance of an institutional investor interested in making an investment in the company.

While interest rates on convertible loans vary, most fall into the six to ten percent range. Because convertible or bridge loans are usually the first outside investment a business receives, the deal is usually sweetened for the bridge lender by including a provision allowing for the conversion of the loan to stock at a 15 to 40 percent discount to the price paid by subsequent investors. Of course terms and conditions vary. Some agreements utilize warrants under a pre-defined formula.

These loans are made under the assumption that it will be converted, however, in the event it is not converted, such loans include alternate repayment terms. These terms vary in a myriad of ways depending on a variety of circumstances. It will suffice to say that bridge loans are replete with qualifying terms, protective provisions and default remedies.

What Are the Flaws

  • In for a penny, in for a pound!
    • The early investor is typically the go to guy when the business needs additional capital
  • The achievement of operational goals and objectives does not guarantee institutional investment
    • Once again, the early investor is on the hook
  • A prospective institutional investor knows he has the upper hand and will almost always insist that the convertible note holder waive all or some of his rights
    • The initial investor has but three options. Waive some rights, come up with the needed capital or allow the company to tank
  • There are no meaningful downside protections for the bridge lender.
    • You can’t get blood from a turnip and you certainly can’t get cash from a bankrupt enterprise.
  • Bridge loans can be a disincentive to the institutional investor
    • Savvy institutional investors know they can sit on the sidelines while angel investors continue to pour capital into the business. Every inbound buck reduces the institutional investor’s risk when and if he finally comes to the table

Bridge Loans Are Not without Significant Downsides for the Founder/Entrepreneur

  • The founder/entrepreneur is often placed in a difficult negotiating position, torn between loyalty to early investors and the demands of institutional investors
  • The founder/entrepreneur is option constrained while the bridge receives value options
  • Bridge note owners can lose focus on what is best for the enterprise to the detriment of the founder/entrepreneur and the business

In Redeye VC, Josh Kopelman, Managing Director of First Round Capital states, One of the reasons I don’t like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur. As a lender, I would convert into the price of the next round — motivating me to keep the next round valuation low. As a shareholder, my motivation is aligned with the entrepreneur — we both get rewarded by a higher second round valuation.

Avoid the Path of Least Resistance

While their simplicity is attractive, convertible notes are not necessarily the best option. Kicking the can down the road with respect to valuation ultimately benefits neither the founder/entrepreneur nor the angel investor.

In What’s the Best Structure for a Pre-VC Investment, Foundry Group’s Brad Feld suggests, … if you don’t believe you are going to raise additional VC money and will only be relying on additional small angel-type investments, the preferred equity approach is fairer to the investors as they’ll more clearly be participating in the upside on terms that are agreed to early in the life of the company.

Generally speaking, those in a position to know favor preferred equity over convertible notes.

 

%d bloggers like this: