Convertible notes, SAFEs, and every other type of convertible equity instrument are to startup financings what bread is to a sandwich, or Ringo is to the Beatles—not the most exciting part, but they’re almost always there, and you’re kinda stuck with them.
In our experience, most early-stage companies use some form of convertible instrument for their initial fundraising round, and I’ll bet that all such companies have at least considered using them.
The use of convertibles is well known and generally a great way for startups to raise money. They are quick, easy, and relatively inexpensive from a legal fee perspective to generate. However, their ubiquity has led to their over-use and misuse. The point of this post is to muse on the convertibles, as our group sees a lot of them, in hopes that our observation of the permutations of what can go right and wrong with their usage might be helpful.
Note and SAFE “Rounds”
The idea of a “Note Round“ or ”SAFE Round“ gets thrown around a lot, and that should probably stop. Convertibles need to be viewed for what they are: a bridge to a fixed-price preferred stock round (think Series Seed, A, B, etc.). Investors don’t jump into a convertible note or SAFE expecting that to be the final destination. Generally speaking, it is usually in a startup’s interest to convert them sooner rather than later, especially when notes have interest accruing.
Viewing a convertible as its own “round” seems to often lead to a behavior of printing convertibles like money and then sitting on them without actively pursuing a preferred stock round, when they really should be deployed as a short-term bridge to get a startup to their next financing ASAP.
Letting convertibles sit outstanding generally leads to i) interest accruing (which leads to holders getting more shares upon conversion) and ii) raising the possibility of you converting folks at the valuation cap, which almost always is undesirable from the perspective of the founders/employees’ common stock ownership.
More Convertibles = More Problems
Investors and founders abhor a complex cap table. When convertible instruments are too heavily relied upon, they can lead to headaches (and even migraines) when you eventually arrive at a fixed price round.
The reality is that you can not sell the same convertible instrument forever, the value of the company will change, and as such, terms like the discount, valuation cap, the interest rate will change over time as the business grows. Other features, like most favored nations clauses, participation rights, information rights, board observer rights, etc., will probably materialize. The first few permutations of a company’s convertibles can be managed; however, as time goes on, the amount of variants can stack and can lead to major diligence issues when you arrive at your round.
More convertibles also mean more conversion math and investor relations to manage when it comes time to get your financing completed. Even with majority amendment clauses (which are, and should be, in most convertible instruments these days), lead investors in fixed priced rounds will often require all convertible holders sign onto things like stock purchase agreements, voting agreements, and investor rights agreements when it comes time to close your round. If you have a lot of disparate convertible holders, this can turn into a huge burden and resource drain when you’re trying to get your financing over the finish line, as needing anyone’s signature invites a host of bad outcomes, like people looking to re-trade transaction points or simply being unavailable.
I think a good number of individual convertible holders is something to the tune of 10 – 20 maximum, and make a point of keeping your instruments homogeneous – avoid signing too many side letters conferring special rights to individual investors or issuing convertibles with differing rights from your other convertibles.
Liquidation Overhang
One less talked about aspect of the valuation cap that is included in many convertibles is how convertible holders who convert at the valuation cap interact with common elements of a fixed price round like liquidation preference and anti-dilution calculations.
In a fixed price round, liquidation preferences are usually tied to the price per share paid by the new investors participating in the financing. Many of these incoming investors take issue with convertible holders (who may be converting their instruments at a substantial discount, especially if they convert at the valuation cap) getting the full liquidation preference received by new investors paying full price for their shares in the round.
This will often lead to investors requiring convertible holder concessions or carving out separate subclasses of preferred to prevent convertible holders from getting a liquidation preference “overhang” in excess of what they effectively paid for their shares.
The question often becomes, “what are the convertible holders entitled to?” Are they only entitled to a liquidation preference that matches the money they have put in, or are they entitled to the same liquidation preference as the new money? Many forms of convertibles are silent or ambiguous to this point, so it’s critical for attorneys drafting these instruments to be clear as to what will happen to these instruments in the event there is an overhang.
SAFEs vs. Notes
A common debate among early-stage companies and investors (generally angel investors) is whether companies should be using convertible notes or SAFEs.
Assuming that the form of these documents is more or less standard, this conversation often revolves around security – what will happen if the company goes to zero, who gets paid?
Most camps will agree that for an investor, a note likely provides more protection. SAFEs are expressly not debt; thus, they reside on the equity side of the balance sheet. Convertible notes are debt on the balance sheet. Thus noteholders have a better likelihood of getting paid something as a general creditor in a wind-down scenario before funds are distributed out to shareholders (though most SAFEs also try to accomplish this, albeit contractually).
That said, I believe this is a false debate. Tech startups, just as an example, are asset lean businesses. In the event of a wind-down, any code or IP is often worthless without the founding team in place to drive it. That leaves desk chairs and MacBooks, which are usually not enough in the aggregate to pay off a bunch of convertible instrument investors. You cannot squeeze blood from a stone.
This brings me back to my earlier point: convertible instruments are not components of a “round,” nor are they a final destination. They are a bridge to a fixed priced financing. Investors and companies alike should target and strive to convert notes as soon as possible. The ownership, rapid capitalization, and growth of startups are where the best outcomes lie for everyone involved.
To wrap this up, convertible instruments, such as convertible notes, are a solid and well-known instrument in the toolbox companies have to raise investment. That said, it’s possible to have too much of a good thing, so pay attention, talk to your attorney and other advisors, and proceed responsibly and sustainably, people.
If you have any questions on the above, please don’t hesitate to reach out. For more related articles, please visit our website, here.
By: Bryant Smick
Disclaimer: this post is for informational/educational purposes only. It is not intended to provide any legal advice.
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