Convertible Notes 101

May 16, 2015

6:00 am

What is a convertible note? I recently had a UK startup ask me this question. While I was surprised, it didn’t take me long to figure out that the financing instrument is not so popular in the UK. The government SEIS and the EIS tax relief schemes started to spur investment from business angels for startups in the region of up to £150K (SEIS) and up to £1M (EIS) prefer pure equity.
To simplify it, a convertible note is a short term loan that is paid back with equity in the future.

This article is a repost of my LinkedIn Pulse post.

 

Relatively easy to administer with minimal legal costs, the idea around it is to solve three issues: Provide immediate source of cash, postpone valuation until business fundamentals are better established, and mobilize/incentivize early supporters for the business.

While those benefits are clearly recognized in Silicon Valley and largely in the US, it’s largely developmental on this side of the Atlantic.

Priced equity is much more preferred on this side of the pond. Much of that has to do with unsophisticated business angels who don’t understand the instrument and its benefits. Convertible notes are seen as quite ‘leading’. One investor, who typically invests £50,000 per ticket on a priced basis (not named for confidential reasons), said to me: “you mean, I’ll get my equity in 1 year, what if the startup dies by then?”

Another investor had this to say, “I am loaning the company money; I am not a shareholder and might never be and as such I can’t exert control.”

For a number of investors, the notion that startups will raise the qualifying round (usually north of $1M or a Series A) in the given timeframe (maturity) is challenged.

On the flip side of the conversation, even the most sophisticated entrepreneur struggles with the instrument and the myriad provisions. Do I offer it with a cap plus discount? No cap and higher discount? Why the interest rate if it’s essentially post dated equity? Exit provision in the event of an acquisition? And what about that Y Combinator SAFE founder friendly alternative (no interest, no maturity). Obviously these provisions are addressed based on the risk profile of the investor. But what if the education process is starting from zero?

Convertible notes are popular among accelerators in the US and they, in effect, helped to educate both entrepreneur and investors about its benefit. This Fenwick Seed Survey reflected back in 2011 the increasing trend to fund deals worth up to $1M on notes. That threshold number is now much larger. Perhaps much of this is easy since in effect, investors must be ‘accredited’, it complements existing government initiatives, and the profile of US investors is much more risk loving.

Image Credit: Images Money

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Chaney is Founder and CEO of VendorMach, a supply chain trust scoring platform. Former technology integration and risk product lead at Humana Inc, he is a sought after speaker on big data and AI trends. He has degrees from Booth, Kings College London and Howard University.

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