The Myths of Convertible Notes
A convertible note (“convertible”) is a loan made to a business whose terms allow the lender to convert the value of the loan into shares in a company, at a specific set of terms.
Disclosure: With VERY few exceptions, I believe that convertibles are significantly founder UN-friendly, cater to the lazy, or inept investor, and can provide significant financial return to savvy venture partners/lenders. Convertible investing may be BETTER for a founder than alternatives, but it’s never a GOOD investment.
Convertibles have been around for a LONG time, but really came into play in the dotcom boom of the late nineties. Why? Well let’s look at what was going on then.
By the mid-nineties AOL had successfully commercialized online experiences for consumers – it had become “your parent’s internet” and, of course, every business needed a website. DOT.COM startups were sprouting like weeds, and every venture fund was under extreme investor pressure to add this sector to their portfolio. It was this digital gold rush, that inflated the bubble, that led to the bust in 2001/2.
The problem was that no one knew how to value a dot.com startup, particularly as most (almost all) had NO path to revenue, let alone profit. And then the inevitable … “how to we put a valuation of this”? At one-point valuation was as simple as “
“How many developers do you have.”?
“Then the valuation is $4M”
That was the conception, and a very short gestation period later, the modern convertible emerged.
Google “what are the advantages of convertible notes”, and you tend to get two general points – and 20M hits:
- Legals are simpler, cheaper and quicker than a priced, equity round.
- Avoids having to value an early stage, probably pre-revenue company.
So, each of these myths:
- This used to be true, but with standardized term sheets, and SAFE agreements, this advantage has been eliminated. And even if there was still some premium to be paid for the legals of an equity round, the cost (in terms of founder dilution) is a rounding error (pun intended) compared to the next point.
- Valuing a pre-revenue company is not hard, I’ve been doing it for fifteen years, and there are half a dozen entrepreneurs walking around Belfast today who can also do it. It takes 15 minutes and a single spreadsheet.
Why then, are convertibles still around?
For starters, it’s usually a much better deal for the investor.
in certain cases, it can represent a 50% discount off the share price … meaning they can buy twice as many shares for the same price. And, depending on the terms of the round where the loan converts to shares, can secure liquidation preferences (i.e. on liquidation, THEY get paid back before any other shareholders) of xN times more than those other investors.
Then there are the philosophical considerations.
If the investor doesn’t know how to value a pre-revenue company, is this really the investor you need?
If the investor does know how to value a pre-revenue company, and yet still chooses to use convertibles, they clearly see the financial advantage, and may even exploit that advantage further, through valuation caps.
So, if you have a choice … before you choose an investment through convertible loans, ask “why do you prefer convertibles”?