Many early stage companies use a financial instrument, called convertible notes, to raise early funding. The basic terms are: immediate investor funding, unsecured debt, conversion to equity whenever equity financing is funded, a stated interest rate and maturity date. However, the instrument is commonly misunderstood. In blunt terms, a convertible note is a “junk bond” and ranks possibly among the highest risk of any investment an investor could make. A convertible note should properly be seen as “bridge” financing—but, that means it needs to be a bridge to something, not just a bridge to nowhere. Thus, convertible notes are only appropriate in the context of an already approved and launched equity financing plan. Equity financing can be extremely hard to raise, in the best of circ*mstances, so early stage companies often find their cash well running dry before an equity raise can be completed. That’s typically when a convertible note becomes relevant.
Important to Note: A convertible note is not itself a financing plan, it is a substitute for a financing plan not yet funded. In short, the company is probably in financial trouble, because it’s equity financing plan is not progressing at the pace needed for the company’s working capital demands.
Convertible note investors should seriously consider that they are highly likely to lose all of their money, and quickly. The company should make this very clear. Importantly, convertible notes are “securities” for federal and state securities law purposes, and so all of the standard exemption and disclosure rules apply, the same as they would for offering stock or other equity securities. Investors should be limited to the wealthiest, most risk-tolerant, least-litigious folks known to mankind. Cancel the sales bravado, shorten the Excel spread sheets, and give ‘em the facts and just the facts ma’am.
Here are terms a convertible note investor should consider requiring of the company, in all fairness:
- A credible term sheet for the equity funding the company needs, including a minimum offering amount that represents an actual success plan, and a maximum offering amount that takes the company to a high multiple exit. The company should be able to identify high-probability prospective investors.
- A valuation based on reality. Once a company gets to a convertible note financing, its valuation must be at a level that makes economic sense and not just the best “blue sky” that a spread sheet can project. Convertible notes properly priced can be highly dilutive.
- The interest rate should be painfully high, but short of usury. Remember the 1990s, when Michael Milken and junk (a/k/a “high yield”) bonds were the rage. The interest rates were risk-adjusted. The same is true today.
- The maturity date should be short. This is not a financial plan, but a stop-gap measure. If the company cannot meet its near-term plan for equity funding, then the balance shifts to the investors, and the maturity date allows the investors to restructure the company that cannot achieve its objectives.
- Include tight covenants, to give investor insider access, and so that significant events require investor buy-in.
- Convertible notes often carry a premium, whether conversion at a discount, or warrants that give an extra kicker for a hoped-for up-side return.
- Remember, the exorbitant interest rate is a fiction and is useful only as leverage when things go south. Don’t pre-spend any accrued but unpaid interest!
Here is how the company should view a convertible note financing:
- This is an investor bail-out, so treat the investors with maximum respect.
- Don’t over negotiate. The terms will likely be tough, but that will all be resolved for the good when the company completes its equity financing plan. But, if not, then the investors will essentially start calling all the shots.
- Tell the investors everything, then tell them some more, and then let them look under the hood, under the skirts, under the . . . well wherever they want to look. The more you disclose, the better for the company. DO NOT keep secrets or resist telling the bad news. It’s kind of like being in a confessional—you can only be absolved from what you confess.
- Make the investors insiders, give them a stake in the company’s success. Board observation rights, board representation, access to information, etc. If the investor doesn’t have a value-added relationship, then that’s the wrong investor in crunch time.
- Be generous in covenants protecting investor rights. Remember, this is high risk investment, and anything to protect the investor is probably good for the company anyhow. The investor WANTS the company to make it through the tough times, as otherwise the investment is lost, so align the investors’ interests with the company’s interests.
This is not the time for shortcuts. Trying to skimp on documentation, or disclosure, or any other details of a complex financial transaction, is bad for the company. Do this one right.
Bottom line: Don’t finance with convertible notes. Unless you must. Don’t invest in convertible note, unless you really must.
