How The Convertible Note Works (Part II: Pros & Cons)

In Part I of this series we discussed the basic structure and concepts of a convertible note. If you have not had a chance to read Part I, and you are unfamiliar with the concept of a convertible note, you may want to take a moment to visit that article to get a full understanding of what’s discussed in this Part II.

Whether you’re an investor or the owner of a startup, it’s important to understand the potential benefits and drawbacks to using this financial instrument as a method of receiving (or giving) a capital injection. As such, this article will highlight some of the generally recognized pros and cons of the convertible note.

PROS

(Startup) Not Giving Up Control – Remember, a convertible note is a debt instrument. Therefore when a business owner issues a convertible note they are not giving up any ownership of their company… at that point. This may be a very important point for a early-stage startup that is extremely concerned with being able to fully control the initial direction and steps of the startup.

Cheaper & Faster than a Full Blown Series Raise – Most startups value any opportunity to get money quickly in order to continue operating the business. Putting together the documents for a full-blown series can run upwards of $50,000 and a lot of time. On the other hand, utilizing a convertible note involves the initial drafting of a 2-3 page document (the promissory note) and costs up to a few thousand. It is also customary for a conversion agreement to be executed as well, which would increase the costs but will still be a lot cheaper and faster than engaging in a Series A round.

No Valuation – One of the most time consuming and disagreed upon aspects of engaging in a Series A round for an early-stage startup is the valuation. Because an early-stage company doesn’t have enough financial history to smoothly valuate its worth, the valuation process can be very difficult. Utilizing a convertible note postpones that discussion until further down the road when the startup has developed a little bit more, which usually causes for a more solid valuation number.

Downside Protection for Investors – Because a convertible note is a debt instrument, an investor’s risk is limited to the amount of the debt owed to him or her. That means that if an investor gives $50,000 in a convertible note, the most he or she will lose is that $50,000 (plus the interest expectation). However, if the startup is dissolved, files bankruptcy, or is otherwise forced to liquidate its assets to pay off creditors, the investor will be senior to any equity holder of the company. This means that the investor will be paid back the money he or she invested before the equity holders are paid anything for their ownership in the company’s stock.

Ability to Offer Different Deals to Different Investors – One of the pain points of engaging in a Series A round is that the terms are set for all investors and they all receive equity based on the same valuation. The beauty of a convertible note is that you can set different conversion terms for different investors. With manipulating the valuation cap and the discount rate, this means that a $50,000 convertible note issued to one investor can be worth more or less than a $50,000 convertible note issued to a different investor. Because of the flexibility of setting these terms, it is a little easier to attract different investors.

CONS

Making a Convertible Note Too Large – A convertible note is usually negotiated based upon a future estimation of what the Series A valuation might be. If a convertible note is made too large, and the discount or market cap terms are too favorable, it may negatively impact the Series A round and the ability for new investors to received adequate amounts of equity.

Racking Up Too Much Convertible Debt – Rather than making one convertible note too large, there is also the possibility of racking up too much convertible debt amongst different investors. This has the same potential issue associated with making a convertible note too large but also carries the potential difficulty of giving affect to all of the different terms between the different convertible notes. This may result in the founders needing to dilute their shares in order to comply with the terms of the different notes.

Auto Conversion Provisions – Most convertible notes automatically convert upon the raising of a Series A round of investments. This means that even if the holder of the note is unhappy with the Series A round terms and valuation, he or she cannot opt to postpone the conversion until the next round.

Flexibility of Terms – Because a convertible note is extremely flexible and negotiable, there is the potential that terms unfavorable to one of the sides (usually the founder) will be included and negatively impact that party at the time of conversion. These terms are sometimes included without the negatively affected party fully understanding the implications of the term(s) at the time of issuing the convertible note.

In short, a convertible note is a very useful tool and has become a commonly used financial instrument. Many startups have benefited from its use, but many have seen the downside of utilizing convertible notes. Whether you’re a Founder or an Investor, understanding the implications of a convertible note, and utilizing an attorney to properly craft and negotiate the terms of that note, is extremely important.

Jamal Jackson, JD/MBA is a corporate attorney licensed in the State of Illinois. He is the CEO & Managing Attorney of Jackson Corporate Law Offices (www.JacksonCounsel.com), Co-Founder of Initiative Consulting Group, LLC (www.initiativecg.com) and a Public/Motivational Speaker engaging audiences in the topic areas of Business, Leadership, and Legacy (www.JamalEJackson.com).