Arbitraging the Convertible Note in Early Stage Financings?

Arbitrage 

A kind of a hedged investment meant to capture a slight difference in price; when there is a difference in the price of something on two difference markets the arbitrageur simultaneously buys at the lower price and sells at the higher price

Convertible Note

 A convertible note is a debt instrument that can be converted into equity at the option of the holder or the issuer.   The cost of borrowing is lower for the seller, with convertible notes, since the buyer has the option of converting it into stock. A convertible note is a way for companies to raise capital without having to use their assets or give up ownership in their company.

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 Lately, some entrepreneurs may be using the convertible debt note as a tool to give them a perceived advantage over early stage/angel investors. I think this is going to cause problems. 

Over the last 6-9 months, I have noticed a proliferation of  early stage companies using convertible notes for their initial funding.  No company or entrepreneur seems to want to “value” their companies anymore (and sell equity) when raising the first round of  early stage capital. All of these companies want to “value” their company at a “later” date when they receive venture capital funding. (Of course, this would assume that all of these companies can raise a round of financing from venture capital funds.) I can count  at least five separate companies in Atlanta alone raising a round of early stage financing that are “opting” to use the convertible note. I talked to a company in California  last week who has raised $1,000,000 to date and wants to raise another $1,000,000 using, you guessed it, a convertible note. A $2,000,000 convertible note?–Wow.

We started using convertible notes in 2002 to solve two issues that often faced angel funded companies just prior to an investment by a VC fund—investment terms and valuation. Often, venture funds wanted to use different terms (and, yes, sometimes a lower valuation) when putting their pooled capital to use. A convertible note investment structure usually allowed the angels and VC’s to work together regarding investment terms and valuation. At the time, we (angels) would almost always get a discount to the Series A share price.

That scenario worked fine for about a year. Then, the VC’s started refusing to honor the discounts. This often put both the angels and the entrepreneurs in an awkward position. The angels received no reward for putting their personal capital to use at an early stage and the founders had to renege on the promises (terms) they made to the angel investors.

So, we bifurcated our model. With companies that we were 80%-90% sure would receive venture funding, we used a convertible note with differing terms that were acceptable to the angel investors as well as the later stage investors. With companies we were not sure had a good chance at receiving venture capital, we negotiated with the company a mutually agreed upon valuation. So, it depends on the future value and success of the company funded as to which investment scenario we will use.

 – Here’s the current rationale of the entrepreneur (and possibly their lawyers) on a convertible note:

1.) A convertible note allows an entrepreneur to raise capital without “pricing” the company at an early stage. This, in theory, allows the entrepreneur/company/angels to not “misprice” the company early on which might cause concern at a later stage by an institutional investor (read VC).

2.) A convertible note allows the entrepreneur to maintain ownership of the company and not sell assets to raise capital.

3.) A convertible note allows the company, using outside capital, to grow and increase the value of company without having to “pay” for it.

4.) A convertible note allows the company to (often) pay back the loan at an early or accelerated date without penalty.

5.) A convertible note is cheap money.

6.) In this market, the entrepreneur can “sell” the convertible note without the investors requiring collateral.

– Here’s why  I think the current rationale will, in time, cause problems:

 1.) Pricing-Not every company that issues a convertible note is going to be able to raise capital from a VC fund. Can you imagine a scenario where the company goes bankrupt, the debt holders receive $0, yet the founder(s) walk away with the remaining assets and/or IP of the company? I do not want to imagine the mess and ruined relationships this scenario would cause.

2.) Ownership-When an angel investor invests in an early stage company, he/she should expect to align their interests with that of the entrepreneur/founder (and vice versa). Being able to buy a equity potion of this company should be expected.  A convertible note gives the possibility of this–but not always the absolute right. Misused, this term will cause problems.

3.) Future Growth-A early investor should be rewarded for putting personal capital at risk. Using an angel’s personal capital in the form of a convertible note to grow a company over time primarily for the founder(s) gain is a misalignment of the risk/reward ratio in this type of investing.

4.) Early payback–If a company takes angel money at an early stage, hits early milestones and increases the value of the company, everyone is happy. That is, except if the company retains the right to accelerate the payback of a convertible note to the early investors before the investors can gain from the value of the company (see above).

5.) Debt is cheap–Yep, it sure is. However, the misuse of this scenario cheapens the relationship between entrepreneurs and early stage investors and will cause the market to tighten for future financings.

6.) Collateral–Using the assets/IP of a company as collateral for an investment (by angels) is perfectly acceptable. It puts a push on the derriere of the entrepreneur/founders and it allows the investor to sleep a little bit easier at night.

What’s the moral of my post? At an early stage, the company raising capital and the angels supplying it should work closely together for a mutually beneficial relationship. Done otherwise, issues will eventually arise and will not be easily solved.

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