Most startup companies, seeking or anticipating high growth, rely on some form of outside financing. That financing can take the form of incurring debt from a creditor (e.g. a bank loan), or selling equity, i.e., ownership, in the business. The variations on these sources are seemingly endless. This blog discusses the pros and cons of one method that has become particularly popular in recent years: convertible notes.
Convertible notes are a debt/equity hybrid. They are debt instruments that include the usual debt terms (e.g. maturity date, an interest rate, etc.), but then convert into equity when future equity is raised. Convertible notes have gained increased popularity in the past decade, particularly with founders of early-stage startups.
Pros
One of the perceived advantages of convertible note financings is they are generally less expensive to draft the required legal documents, and to close. A typical equity financing requires the updating of numerous corporate documents to close: certificates of incorporation, operating agreements, shareholder agreements, voting agreements, and others. This not only increases the expense, but the time involved before equity funding can occur.
A second advantage may be delaying company valuation. To sell equity, some matrix is used to determine company value. Absent a history of revenue, this can be a challenge. Raising funds by using a convertible note allows the company to delay the valuation.
Cons
The expectation behind the issuance of a convertible note is that at some point, the company will be in a position to make an equity offering and pay off the debt incurred in the form of a conversion to equity. If the company is not in a position to do that by the time the term of the note expires, they may not be able to make the conversion. If the company is a startup, working hard to put in place infrastructure and develop a product, they may be burning cash without producing much revenue. One potential solution is to include a provision for an automatic conversion on maturity. However, the more detailed the terms and provisions for an automatic conversion are, the more you lose the benefits of using a convertible note in the first place.
Takeaway
If you are considering using a convertible note as a funding source, be sure to understand the implications. What happens if you are not in a position to make an equity offering when the note term expires. Consider equally how the note terms will affect your equity share in the company if you’ve been able to outperform your expectations when the conversion date arrives.
Need legal advice in guiding your startup? Contact CASHMAN LAW today for a free consultation to see how we might help you with the growth and management of your business.
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