Watch Out for Convertible Notes

December 18, 2013

1:00 pm

I’ve written before about the merits of convertible equity for the startup. Recently, I heard about companies that took convertible notes as bridge loans, so I thought it useful to again highlight the potential pitfalls. As you know, a convertible note is a form of a loan. Typically it is converted into stock of the company at a future round of financing. But if there is no future round of financing, the lender (investor) can call the note and demand repayment. In the stories I just heard, when the companies couldn’t repay the notes, the lenders (the investors) foreclosed.

In one case, a VC firm was seriously considering investing in a company. The VC firm, legitimately, needed information from the company that would have cost some dollars to create (legal opinions, market studies, patent analyses, and so forth). So the VC firm issued to the company a bridge loan which was to be repaid out of the proceeds from the pending investment. The funds from the note were specifically earmarked toward the expenses associated with due diligence. The VC firm did their due diligence and issued a term sheet to the company. Much to the investors’ shock, the board of the startup rejected the term sheet believing that they could get a better offer if they continued to shop the company. The VC firm recoiled in disgust, and let them go about their business. When they failed to get a better offer, they came back to the VC firm with their hat in hand. The VC firm foreclosed on the note and took over the company.

This sort of behavior is what gives VCs a bad name, and it echoes a snippet I once saw of Shark Tank. But I have to say in this case, I’m on the side of the VCs. The startup should have known what the risks were of taking the note from a potential investor. If they had used Convertible Equity (assuming the VC firm would have gone along), they would still have their company, although apparently they would have no money. I wonder, too, if they had a decent attorney who might have been able to anticipate, and possibly avoid, this unfortunate circumstance.

This was reminiscent of a story I heard at the height of the dot-com boom about a company financed mostly by, and controlled by, angel investors, that rejected a VC’s term sheet only to subsequently go out of business when they couldn’t get a better offer.

Today I heard a nearly identical story about a company that is gasping to hang on because they are out of money, having spent the bridge loan proceeds, and their lender (investor) is about to take them over.

My sympathies almost always go to the entrepreneurs. Their fortunes and careers will have a much harder time recovering than a VC firm that loses a few hundred thousand dollars on a bridge loan. But at the same time, I wonder if these companies knew what they were getting into and if they had their eyes wide open. Caveat emptor.

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Neil Kane, the Director of Undergraduate Entrepreneurship at Michigan State University, is a leading authority on technology commercialization and innovation and has the battle scars to prove it. He was named a Technology Pioneer by the World Economic Forum in 2007. His Twitter handle is @neildkane. He’s also on Google+ and LinkedIn.

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