The Pros and Cons of Convertible Notes
28/10/2019 — by Ching Hei Cheung
Considering issuing convertible notes to investors as a method of fundraising your startup?
Here are the advantages and pitfalls of this mode of financing as well as how Zegal’s custom templates can assist your investment process from its early stages of negotiation to converting into equity during future financing rounds.
A convertible note is a short-term debt instrument that converts into equity. This process, typically facilitated by the use of a Convertible Note Term Sheet, allows investors to loan money to a startup and, instead of a return in the form of principal plus interest, converts into equity in the company when triggered by a subsequent fundraise. A convertible note term sheet is a non-legally binding document recording the negotiations between a company and its investors for the issue of convertible notes. However, given the fact that this document is not legally binding and cannot be used on its own to execute a convertible note, it is necessary for parties to construct a Convertible Note Instrument or Convertible Note Subscription Agreement to set forth the agreement’s legally binding terms in full. Ensure that all components of the negotiation process are documented clearly and that the agreement itself is executed with precision through the use of Zegal’s Convertible Note templates, designed as a catalyst to your process from negotiations with investors to due payment of the agreed investment amount.
The point of issuing convertible notes is for it to convert into equity for investors at some point in the future, and not for it to stay outstanding indefinitely. Thus, these conversions will likely be caused by one or numerous ‘conversion triggers’. One common example of a conversion trigger is the next qualified round of a business; this is known as the situation when the round is big enough to accommodate the amount stated in the note and facilitate the progress of the company’s growth with additional expected rights given to investors once their shares are converted from loan to equity. Another example of a conversion trigger is an expiration maturity date of the note, in which case the note holder can either ask for their money back or seek to convert the outstanding amount accumulated by that company at that point. Lastly, upon a change of control event in the future and before the convertible note is converted into equity for investors, it is possible to ask for a multiple of their loan back as payment in lieu of converting to ordinary shares prior to the completion of the change of control event.
The main advantage of issuing convertible notes to investors as opposed to conventional debt financing is that it does not force the issuer and investors to determine the valuation of the company. This is especially useful in the case of startup companies as it may be difficult to determine the definitive valuation of a business that has yet to be taken into its true fruition. Thus, it seems as though this security-type in early stage financings serves as a method of investing without bearing the risk of determining an incorrect valuation amount. The simple and straightforward nature of a convertible note’s structure means that startup financing rounds do not have to bear the grave time costs as well as money expenses because unlike priced rounds, convertible notes do not sell actual ownership stakes to investors. By contrast, since convertible notes are technically a form of debt, there is no need to issue common stocks to investors, thus, saving the hassle of company valuation complications, stock option grants, or tax implications. Entrepreneurs may find this method favourable as it means more time can be focused on the actual content and daily operations of the startup itself.
This is known as the value of the company at the time the investment is made which, while convenient in cases of startup companies, can also be equally contentious as it is supposed to determine what percentage of the company is being offered to the investor. Convertible notes allow issuers to defer valuation negotiations, thus, allowing the company to progress into later stages of funding to determine a fair price through more advanced metrics later on in the lifecycle of the business. One notable feature of convertible notes is that it typically includes a discount rate to the fully diluted price per share, thus benefiting investors who are willing to take the risk of investing in a company before a definitive valuation can be made. Similarly, the convertible note’s valuation cap, otherwise referred to as a price cap or conversion cap, establishes a maximum value of the conversion price at that future financing; further promoting fairness in investing whereby noteholders convert their investment into equity at a more reasonable and favourable price per share. For more information on valuation caps and discount rates, consult Zegal’s Convertible Note Term Sheet legal document or the Shareholder’s Resolution to Issue Convertible Notes template document.
By nature of the aforementioned valuation cap, regardless of how profitable the company is, convertible bondholders receive a fixed income until shares are converted to equity. This serves as an advantageous reason for companies to issue convertible notes in the first place as it means that more of the operating income is available for common stockholders who invest at a higher price per share. In addition, the company only has to share operating income with converted shareholders and, since they are not entitled to vote for directors like common stockholders, if the management group of a company is apprehensive about losing voting control during discussions around alternative means of financing, then convertible notes will serve as an advantage as opposed to ordinary common stocks.
Lack of Control
However, while convertible notes can be used to decrease risks associated with the ambiguities of valuation during the early stages of a startup company, there are also numerous disadvantages and areas of contention that may discourage investors from choosing this method of funding. For new investors and entrepreneurs investing into a company for the first time, it can be difficult to determine whether the terms of a particular convertible note offer are fair or not, and thus, failing to provide the same sense of assurance and security as normal investments. Ultimately, the investor or entrepreneur may prefer to wait for a priced round where the company has developed quantitative and tangible metrics on its valuation before they invest, even if they know it means they will likely pay a higher price than they could have. The reason why investors may not want to engage in a convertible note agreement in lieu of an ordinary investment is because these investors are typically wary of foregoing the rights typically associated with being a shareholder, such as: voting rights, control rights, pro-rata rights, and liquidation preferences. Furthermore, convertible notes do not usually offer long-term capital gains treatment until after the note is converted.
For many investors, the notion of unforeseeability which pertains to opting for convertible notes is what keeps them from utilising this method of financing. The main issue of contention is how investors should act if the company ultimately cannot raise the subsequent equity financing that was expected in the beginning stages of the investment; this is because it is not a mandatory requirement for all convertible notes to include provisions or clauses for an automatic conversion on maturity, thus, it is common for startup companies to not have sufficient money to repay the funds, should it not convert. The best way for a company and investor to avoid this situation and negate all uncertainty or ambiguity regarding a convertible note is to clearly address all terms of the agreement as well as an automatic conversion clause within an Ordinary Shares Term Sheet, before reiterating these terms onto a Convertible Note Instrument that the investor can subscribe and intermittently refer to via a Convertible Note Certificate. All aforementioned documents and guidelines for constructing these agreements can be found on the Zegal app, ensuring that you are able to enter into negotiations and issue shares through convertible notes securely and beneficially.
As a startup company, it is of quintessential necessity to rely on some form of outside financing; from angel funds to traditional venture capitalists. Convertible notes have become increasingly popular as a funding mechanism for startup companies, however, it is often times referred to as a double-edged sword as a result of its unpredictable nature and seeming lack of control due to the unknown valuation of the company. For a startup company to successfully engage with issuing convertible notes and give way for both parties to benefit the most from the successes of its growth, both the company and investors must understand the potential pitfalls of this method of financing, and negotiate the terms of the agreement clearly with the assistance of Zegal’s templates that can be used at all stages of the investment process.
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
Ching Hei Cheung is a first-year law student and aspiring solicitor studying at the University of Bristol. She is involved in a myriad of extra-curricular activities such as debating team where she has obtained first place in a national competition judged by a panel of legal professionals from Baker McKenzie, commercial awareness society and pro-bono society, in order to refine existing skills in public speaking and negotiations, as well as develop a greater understanding of the commercial market that encapsulates the everyday workings of the legal sector.