The Investor Perspective: Convertible Notes vs. Preferred Stock

Legendary investor and former bank president John O. Huston offers a terrific comparison of these two investment vehicles. Which is best? There is no right answer, of course, as it all depends on the circumstances. But the summary here gives you a snapshot of the issues to be considered.

OverviewThe three points below summarize John’s perspective:

  • “Convertible Notes are inherently neither good nor bad.”It depends upon whether you are the founder, purchaser, or a BOD member … and the specific financing situation, needs and challenges faced by the company.
  • “I prefer to settle on the valuation, and then buy Preferred Equity.” Agreeing up front on the value gives everyone a clear view of what it will take in terms of business success to drive a lucrative exit for the benefit of all shareholders.
  • “I like an inside round of Convertible Notes to build a quick cash cushion when entering due diligence for an exit.”

Here Are the Details – Generally, if you are an investor who buys Convertible Notes which convert to equity at the next equity round, here’s what you get::

Positives

• Each lender holds a loaded pistol (final maturity).
• You can threaten bankruptcy – the ultimate clout.
• Get paid before equity in both scenarios.
• Simpler documentation.
• Avoid haggling over valuation until next equity round.
• Convert into the next equity round at a discount.

Negatives

• “Loan to own” may make you an owner.
• You may need an Inter-creditor Agreement.
• Often unsecured (or behind others).
• No BOD seat or exit vote.
• Others will set the price.
• “Gold Holders” (with special positions) may object.

But if you own Preferred Stock while others, including the entrepreneur, own Common Stock, the world looks like this:

Positives

  • Unlimited upside potential returns
  • BOD seat likely for each early round
  • Must approve sale of future debt/equity and company
  • Get paid before founders/common shareholders

Negatives

  • Dilution can destroy returns
  • Will Directors drive an exit?
  • Complex documentation
  • “Gold Holders” set the rules

Takeaways

  1. Investors should always presume that holders of either Convertible Notes or Equity will receive no cash before the exit.
  2. At maturity, all noteholders will hold a hammer, so consider how “strangers” sharing the same security will react if the company does not raise equity before the note matures.
  3. All the documentation protections of both notes and equity can be renegotiated by the lead investor of the next round. The main difference is that noteholders can kill the company at maturity but stockholders must wait for it to run out of cash. In other words, lousy performance is not an “Event of Default” which would allow lenders to step in.
  4. Although noteholders get paid first in a liquidation, such proceeds are usually nil so this feature rarely minimizes losses.

Convertible Notes: Advantages & Disadvantages

  • Overview Convertible Notes can be viewed as being either a tremendous opportunity or a toxic financing vehicle depending upon their specific terms and conditions. They also look very different depending on whether one is selling, buying, or approving them. There are two key questions to keep in mind:
  1. Who will lead the equity round into which the notes convert? Will it be an “inside round” (i.e. comprised of current noteholders and shareholders) or an “outside round” (i.e. must involve a significant number of new investors in order to fill out the round)? Obviously it is much more likely that the conversion discount – typically a 20% discount to the price of the next offering – will be honored for an inside But beware: There are hundreds of stories about VC investors who will only invest if the noteholders agree to “give up their discount.”
  2. What is the relative likelihood of the venture’s possible outcomes? BODs should expect experienced investors to employ an “Outcomes Map” when assessing their note purchase For instance, many young ventures selling Convertible Notes face at least these eight possible outcomes:
  3. Go out of
  4. Find growth internally, never raising any more capital prior to the
  5. Sell more
  6. Sell more
  7. Sell both more debt and equity (in which order?).
  8. Be bought prior to ever raising more
  9. Be eventually bought (or IPO-ed) after raising subsequent rounds of
  10. Become a Zombie (surviving at cashflow breakeven but incapable of attracting an acquirer).

Comparison From Different Perspectives – The advantages and disadvantages below are grouped into three vantage points: That of the entrepreneur, a BOD member, and the Early Stage investor considering buying the notes. Their sensitivity to the “inside/outside” and “Outcomes Map” issues often vary greatly, which affects their assessment of the appropriateness of Convertible Notes for this venture at the time they are offered.

Entrepreneurs’ Viewpoint

  • Advantages Compared to Raising a Priced Preferred Equity Round:
  1. Investors can delay placing a valuation on the venture, while they use the note proceeds to hopefully increase the valuation when the next equity round is
  2. Investors can close this raise of capital sooner, easier and
    1. More investors (at least newer investors) are more familiar with debt than equity
    2. The paperwork is less
    3. It avoids negotiating valuation, speeding the
    4. Investors can avoid the discussion of whether the venture should be an LLC or a C Corporation which would qualify for QSBS treatment under the Internal Revenue
    5. For smaller rounds, investors can minimize total transaction costs as a percentage of the capital
  3. Until the notes convert, the entrepreneur is raising non-dilutive financing (unless forced to provide warrant coverage) to get debt players to invest in the note.
  4. Note buyers do not usually request a seat on the Board of
  5. Note buyers do not expect to have much say over how the company is run (i.e. not the usual protective provisions equity buyers expect).
  6. The entrepreneur may not have to provide noteholders as much financial reporting or even an annual
  7. Just like accrued stock dividends, the note interest accrues until conversion, conserving precious
  8. If the venture fails, noteholders will be paid first from any liquidation proceeds. The shareholders (including the entrepreneur) are less likely to receive anything once the notes sell. However, the odds of the venture’s demise are perceived by the entrepreneur to be low. And, in liquidation, shareholders rarely get anything Therefore, the company is not really hurting other shareholders by selling notes.
  9. If the venture is successfully exited at a profit, selling notes in the early rounds may have reduced the entrepreneur’s dilution – this presuming a nice uptick in share price for the round into which these notes will
  10. A high valuation cap that will signal the next round investors of the company’s worth in the minds of noteholders, and this might set the pricing
  11. If VCs can be convinced to lead the next equity round, they might dishonor the conversion discount, expunge the accrued interest or require the noteholders to convert to common (or all of the above). Any one of these “cram downs” will benefit the entrepreneur (as the largest holder of Common Shares) since the fewer Preferred Shares outstanding, the better for all Common
  12. If the company is sold before the need to raise the next equity round, the noteholders might only get back their principal and interest, thereby boosting shareholders’
  13. If the company can be bootstrapped, avoiding the need to sell any equity in the future, the shareholders may agree to an extended repayment plan, thereby retaining the entrepreneur’s ownership
  • Disadvantages Compared to Raising a Priced Preferred Equity Round:
  1. Since noteholders at maturity will be holding an expired note, the company must hope that they won’t try to extract onerous terms by threatening bankruptcy. Therefore, the entrepreneur should only sell Convertible Notes to people they trust, decreasing the pool of potential
  2. Each unpaid noteholder can declare an Event of Default at maturity, so there might need to be an Inter-creditor Agreement, adding substantially to this note round’s legal cost and protracting the negotiations.
  3. If note buyers require collateral, filing the UCC-1 will notify customers and suppliers that the company had to pledge its assets in order to borrow
  4. Noteholders will probably want veto power over selling additional debt (even if they are unsecured), and their approval may not be forthcoming – or come without a
  5. If the noteholders must approve the sale of equity, they could refuse to approve future rounds, preferring to be paid back over time, thereby precluding access to growth capital.
  6. Noteholders must be paid their principal and interest before shareholders receive any proceeds, so in essence they have the same 1X liquidation preference that preferred equity holders
  7. Selling Convertible Notes causes obvious NRI (Next Round Incongruence) because the BOD will want to raise the next equity round at the highest possible price for the benefit of all shareholders, but noteholders benefit from the lowest possible price (so that they will convert into a larger ownership position). This causes goal incompatibility among those who have funded the venture to
  8. The entrepreneur might benefit from having a Board of Directors that includes noteholders, but they may decline to join the BOD due to the obvious NRI conflict of interest.
  9. If selling notes delays forming a BOD, then the entrepreneur is forestalling their own learning on how to manage the company – and the noteholders are part of a company with much less guidance.
  10. If the notes allow holders to sell them to third parties, the company could end up with unknown creditors or worse, predatory “Loan to Own”
  11. If some note buyers naively think that they can be paid back at maturity, this would cause tension since this is highly
  12. If the notes contain any financial covenants, the company might have to renegotiate them from a position of weakness (if they are out of compliance) plus incur extra legal fees for amendments and
  13. Noteholders might want an enhanced return if the entrepreneur is able to sell the company before the need to raise the next equity round. They might require an exit preference that is greater than the usual 1X liquidation preference preferred buyers expect (i.e. perhaps 1.5-3X).
  14. The conversion of the interest on the notes (typically 10% per annum) into Preferred Equity further dilutes CEO ownership, stacking more Preferred shares on top of the entrepreneur’s Common s
  15. When the company raises the next equity round and the notes convert per their terms, then the post-money valuation will be bloated by the sum of their principal + accrued interest + conversion discount – when the company has already spent the principal. This puts added pressure on the entrepreneur to grow the company into this higher valuation or face a down round at the next equity raise.
  16. If the lead of the next round requires changes to the conversion terms of the notes, they might be tough to negotiate, causing delay plus discord among the noteholders and the new equity providers.
  17. If the leaders of the next equity round do not honor the note’s discount, there will be hard feelings among and towards the Directors – whether or not noteholders are on the BOD.
  18. Even with no noteholders on the BOD, if their discount is dishonored they will probably be disinclined to provide any future financial support to the company.
  19. If the note buyers require a cap on the next round’s valuation, whatever is agreed to might be used by the round’s lead investors as the ceiling, and not the

From the Note Buyers’/Investors’ View point

  • Advantages compared to buying Preferred Stock:
  1. Due to their speed, a hotly pursued deal can be taken off the market before those requiring preference shares can negotiate their term
  2. By avoiding the valuation discussion (with or without a valuation), the investor can swiftly build trust and rapport with the entrepreneur (and friends, family, and prior equity buyers).
  3. Notes enable the investor to delay making the decision of whether converting to a C Corp is wise at this This is often a problem with equity buyers who might be divided between preferring the LLC or C Corp legal structure, although the world is “moving C” at the moment.
  4. Creditors get principal and interest before shareholders receive any distributions, yet avoid having to explain to the entrepreneur the usual 1X preference Preferred Stock buyers
  5. If the notes are merely a short-term bridge to the equity round which noteholders will also be leading, then there is no risk of having the discount disregarded. After all, this is the original purpose for which Convertible Notes were designed – bridging to an equity round already under
  6. Convertible Notes work well for sudden, temporary cashflow shortfalls so long as the next round will be an inside round. For instance, they nicely enable covering payroll if the closing of an equity round already in documentation is
  7. If a Letter of Intent from a potential buyer arrives and investors want to build a war chest to withstand protracted due diligence, Convertible Notes sold to current investors may avoid having to get shareholders votes at a crucial
  8. If note investors negotiate a valuation cap on the price at which the note will convert, then they may have set a valuation ceiling for the next
  9. If the company is underperforming and a priced down round is the alternative, Convertible Notes allow the investor to avoid triggering the complicated anti-dilution mechanism which usually impacts morale the company and among option
  10. Lower legal fees from a note instrument mean more of investor capital goes into growing the
  11. It might be easier to fill out a note round (presuming more investors prefer notes to equity).
  12. Note investors can exert 100% control over all future capital raises (or at least the issuance of further debt) which means that even if the notes are not currently collateralized, it is possible to preclude others from being given any
  13. If the notes are collateralized, then it may be possible to retain first lien position when additional debt is raised, and as the company gains more traction, the likelihood of total loss should diminish if there are any assets with fire sale
  14. Unless paid at maturity, noteholders might be able to extract onerous terms in exchange for an As a shareholder, there is no clout until a vote is needed under the equity protective provisions.
  15. Investors concerned about pernicious behavior by other noteholders might be able to mitigate this risk via an Inter-Creditor A
  16. If there is concern about whether the leaders of the next equity round will honor the conversion discount, it might be possible to get warrants, even though they will only enable the purchase of Common Stock.
  17. If the note provides an option on automatic conversion into the next equity round, there is a free option to participate, keep the note or negotiate other terms – presuming the company cannot simply return principal plus
  18. If the investor can negotiate some financial performance covenants, every violation provides an opportunity for improving terms.
  • Disadvantages Compared to Buying Preferred Stock:
  1. If the next equity round will be led by a new investor not already on the cap table (i.e. an “outside round”) then current investors take a significant risk that investors they have yet to meet will honor the terms of these notes. This is especially true if the new investors are VCs whose primary fiduciary responsibility is to their LPs, not to the Early Stage investors who have financed the venture to
  2. The long term capital gains clock only starts ticking when the notes convert into equity. When the investor buys equity, there will be long-term capital gains treatment if the company is suddenly sold after 366
  3. If the company is suddenly sold prior to the next round, even if there is a 1.5-2X liquidation preference, this is a capped return. Had the investor bought equity, the upside would be
  4. If the venture is a C Corp qualifying for QSBS treatment under the Internal Revenue Code, then “starting the clock” is even more important in order to qualify for the special tax treatment via IRC This section can shield investors from all federal income taxes on gains from the sale of such stock if held for at least five years (capped at $10 million of gains or 10 times your investment). Buying notes does not enable this treatment, and the time limit clock only starts ticking upon conversion to equity. (THIS IS NOT TAX OR ACCOUNTING ADVICE. Consult your professional tax advisor regarding IRC Sections 1202, 1045, and 1244 that apply to stock purchased from QSBS issuers.)
  5. Note sellers do not routinely receive a BOD or Observer seat, robust information rights, or protective
  6. Convertible Notes often lack Pro Rata rights enabling the investor to increase their holders in the future. To think that the company has used debt capital to grow to the point of warranting a higher valuation, and then not allowing the investor to invest further (which Preferred Stock owners are routinely granted) is off-putting.
  7. If multiple creditors are involved, then the rights and remedies as a lender may be neutered substantially by an Inter-Creditor A
  8. The noteholder may hold a hammer at maturity, but also feel intense pressure from fellow noteholders to go along with any restructuring. Net, holding an expired note is typically not that
  9. If the note is “uncapped,” the investor takes the risk that those pricing the next equity round will do so Otherwise, the discount (if honored) will provide little protection.
  10. If the note is “capped,” then the investor takes the risk that those pricing the next equity round will view it as the highest possible valuation they need to offer. If the noteholder is also a shareholder, this might lower total returns – because there is more dilution than might occur if the notes had not been
  11. After the first equity round has been sold (past the Friends & Family round), Capital Access Plans rarely include plans for a Convertible Note round prior to exit. Therefore, selling them is an admission that the company is off track. Buying them represents a large “dope slap” risk if the venture subsequently fails, since the company was clearly underperforming at the time of
  12. Even if a conversion discount is honored, several studies suggest that it provides an inadequate return for the risk taken at this juncture in the venture’s life
  13. By lending the venture cash via a Convertible Note, an investor is helping it attain a higher valuation in the next round. But if they are successful in negotiating it, this reduces the noteholder’s ownership position, thereby lowering the potential

 Directors’ View point On This Choice

  • Advantages compared to selling a priced Preferred Equity round:
  1. Selling notes can be faster, easier, and cheaper thereby enabling management to divert less time and attention to raising
  2. The BOD is protecting all shareholders by avoiding an up, flat or down round, at least at the moment. (These days, note buyers almost always insist on a conversion cap, so this benefit may be muted.)
  3. If the company is so far behind plan that a down round would be likely, then by selling notes the BOD is avoiding the negative impact on the team’s morale, giving them a chance to improve results and hopefully warrant a price uptick in the next
  4. Likewise, a down round might put all employee options “under water” further hurting morale and motivation.
  5. Even if the company fails, shareholders’ returns are not likely to be lessened by the new noteholders’ having the first call on any liquidation proceeds. Therefore, placing debt holders ahead of them is not likely to significantly lessen their liquidation proceeds if we must cease
  6. If the company foresees missing the next payroll or two, a quick inside Convertible Note round can probably raise cash faster than a priced
  7. Likewise, if we are entering Due Diligence with a strategic or VC investor, building a cash cushion for possibly protracted negotiations can probably be done easier with Convertible Notes than equity. In fact, the new investors might prohibit the company selling more equity during their Due
  8. If a buyer’s Letter of Intent suddenly arrives, selling notes to insiders to build a war chest might be far preferable to gaining approval of all shareholders for selling more
  • Disadvantages compared to selling a priced Preferred Equity round:
  1. The BOD must understand the Zone of Insolvency and whether it is applicable. If it is, then this might be a surprise to shareholders as the BOD’s primary fiduciary duty shifts from them to
  2. The risk of a future down round is increased due to the bloated post money valuation caused by the note
  3. Because noteholders hold a hammer at maturity, the BOD must have a better grasp of the likely behavior of these individuals. One “shark” can ruin a company and the BOD may be criticized for bringing aboard such an investor.
  4. Directors should be expected to participate in the company’s fund raising rounds. Many BOD members may prefer to invest much larger amounts in their own portfolio companies. However, if a Director buys Convertible Notes, their Next Round Incongruence (NRI) is both painful and obvious. They can either decline to buy the notes, stating this inherent conflict, or buy them and possibly be accused of not seeking the highest possible valuation in the next equity round.
  5. If a BOD member is a noteholder and the leaders of the next equity round change any of the notes’ terms and conditions, fellow noteholders might complain about the Director “selling out” the noteholders.
  6. A BOD member’s reputation might also suffer if any note buyers did not understand the low likelihood that they will ever receive any principal or interest prior to the company’s

SUMMARY – Convertible Notes are neither “good” nor “bad.” Their appropriateness as a financing vehicle is affected by:

  • Whether the equity round into which they convert will be an “inside” or “outside”
  • The venture’s most likely scenario from the Outcomes
  • The viewpoint of the individuals involved (whether they are the entrepreneur, BOD member, or potential purchaser).
  • A full understanding of the terms and conditions needed to fill out the

 

Source: John Huston: jh@OhioTechAngels.com (160507).