Nice Convertible...a few words on Convertible Notes

Marianne Hudson (Executive Director of the Angel Capital Association) did a quick survey of angel investors on convertible notes recently, and summarized the responses in an article for Forbes.  It was interesting to see that 82% of the angels she talked to preferred not to use convertible notes, but that 78% had done a convertible note financing in the prior 18 months.  Which means there are a lot of angels doing note deals who would rather be buying shares.

I'm always surprised when a new entrepreneur or angel comes into our offices with a very strong opinion on convertible notes, either very intent on only doing a convertible note round or insistent that they would never use convertible notes.  Usually, their reasons come from things they've read online, which are often incomplete or inaccurate.

I would agree with the few angels in Marianne's survey who are fine doing either priced rounds or convertible notes, depending on the situation.  As the article says, convertible notes are just another tool that can be used to finance startups.  And in some situations, they are the best option.

Priced Round
— A financing in which a price-per-share (and therefore the Company's valuation) is negotiated and set at the time of the financing. A convertible note financing is not a priced round; in fact that's one of its chief advantages in some situations.

 

Background: Bridge Financings

In the late 90s and early 2000s, we really only used convertible notes in true "bridge financing" situations -- meaning a situation where a company was in the process of getting together a larger financing round, but needed some money quickly (e.g., to make payroll and pay rent) while the deal was closing.  In these cases, the company's current investors and/or the new investors in the new financing would put a little money together for a 'bridge' to get the company through to the bigger closing, and this interim financing would be structured as a convertible note (often with a warrant sweetener), basically as an advance against the upcoming financing.  This way it could automatically convert into the new shares once the bigger financing was closed but, if for some reason, the company couldn't get the round closed, it would remain as a debt on the company's books, and the investors advancing the funds would have a good claim to repayment.

Bridge to Nowhere
— A term investors use for a bridge financing in which the follow-on financing (into which the bridge was intended to convert) seems to never occur. Sometimes called "a bridge that turned into a dock."

Expanding Use of Convertible Notes

As the 2000s wore on, however, it became more common to use convertible note financings in situations even in "non-bridge situations" - i.e., when a specific larger round of financing was not in the works.  In fact, in many cases, a company will use a convertible note financing even when the company never intends to raise another round of financing.

The advantages that convertible notes have even in non-bridge situations are due to:

  • the relatively simple terms of a bridge financing (as opposed to, for example, a preferred stock financing), which saves on time and legal fees, and
  • the fact that there is no need to set a valuation for the company in order to close the round and put the money to work.  

Some terms of convertible notes have evolved to better fit the situations in which they're used now.  Primarily, the "Cap" used in the notes has become far more important than it was in the bridge scenarios.  The "Cap" is included to protect the angel investors from the so-called "runaway success problem"  which has become a much bigger likelihood now that startups can achieve massive valuations without having to raise bigger rounds of money.

But more on the the Runaway Success Problem, the Cap and other key terms of Convertible Notes in a later post...