Pros and Cons of Convertible Notes

In the previous article, we studied what convertible notes are and how they are used in the context of financing a startup firm. The various terms and conditions which are generally a part of the convertible notes agreement were also explained along with the working of the note. However, before investors and founders make a choice about whether or not they want to use convertible notes, they must fully understand its pros and cons.

This article provides a detailed explanation of the pros and cons associated with convertible notes.

Advantages of Convertible Notes

The advantages of convertible notes have been listed below:

• Huge Upside: Angel investors typically use convertible notes to invest in a company which they believe has a huge upside. A convertible note is a relatively safe way to obtain a good chunk of equity in a corporation in the seed funding stage. If the corporation does not make it to the next stage, then the investment will be treated as debt and the investors will be repaid whatever is possible by liquidating their assets. However, if the corporation does make it to the next stage, investors can acquire a significant stake at a discount to the market rate.

• Less Expensive: The process of issuing convertible notes is much simpler and less time-consuming as compared to other forms of financing. Also, since the process is largely informal in nature and no valuation has to be agreed upon, the time taken for the paperwork as well as the legalities are quite less. This also means that there are lower transaction costs associated with such financing. Lower transaction costs are quite lucrative for startups that are yet in the pre-seed-funding stage.

• Delays Valuation: Both the investors and founders are not comfortable valuing the firm at a very early stage. This is because, at this stage, firms haven’t had the opportunity to display the traction which they have generated within their industry. Hence, investors feel that they will be given a lower valuation while investors are afraid that they might end up overpaying for the company. Both the investors as well as the founders want to delay the valuation decision as much as possible. Convertible notes allow the firm to do so and hence are preferred by both parties.

• Valuation Cap: Most convertible notes also have a valuation cap clause. This clause ensures that the firm does not end up giving too much of its stake at a low price. The valuation cap puts a cap on the maximum amount of equity that can be transferred to the investors when the conversion happens. This feature makes the founders feel comfortable while using these notes.

Disadvantages of Investing in Convertible Notes

Convertible notes are criticized on several grounds. It is said that these notes have several disadvantages, some of which, have been mentioned below.

• High Risk: Convertible notes can be very risky investments. This is because if the firm does not find another investor who can give them a good valuation, then they will be bound to repay the notes with cash. Also, since the amount of the notes is considered to be debt, the firm may have to liquidate its assets in order to pay off this debt. This is a bad situation for both the founders as well as the investors. On the one hand, the founders' company can go bankrupt in the process while on the other hand, the investors can also lose all of their money.

• Lack of Control: In most cases, the true value of convertible notes is not determined either by the investor or by the founders. Instead, it is determined by third-party investors who invest in the company at a later stage. These investors decide the valuation of the firm. This valuation is used to determine the valuation of the notes. It is common for both investors as well as founders to try to manipulate the valuation provided by the third party in order to gain an upper hand.

• Equity Dilution: Convertible notes are a form of early-stage financing. Any form of early-stage financing causes the company to offload its shares at a very low valuation. Prudent founders want to avoid committing any equity of their firm at this early stage. Hence, they prefer to use either the debt route or their own funds. Selling equity at a very early stage is basically the equivalent of selling its equity at a very low price.

• Complications: It is possible for the same startup company to sell convertible notes to a wide variety of investors. Hence, in such cases, multiple parties tend to get involved. If the deal is not structured properly, then these multiple parties can have conflicting interests as well. This can create a lot of hassles at later stages. Hence, it is advisable for any company to ensure that there are no complications since the interests of all stakeholders will be negatively impacted.

Convertible notes are generally considered to be a dangerous proposition and form a part of an aggressive financing strategy. Investors, as well as founders, need to carefully consider their pros and cons before deciding on whether to use it or not.