By Brian Parks, CFA, Managing Director of Technology Lending, P2Binvestor
Congratulations: You pounded the pavement, brought in outside capital, and spent the last 12 months putting it to work to get your business off the ground. Now, your convertible notes are due to mature in six months and you’re wondering, what’s next? At this point, there are two possible outcomes.
- Your notes convert to preferred equity
- Your notes do not convert
Multiple paths lead to these two outcomes with each path carrying its own implications for your business. Let’s take a look at each path and the various obstacles you may encounter along each.
Disclaimer: I am not an attorney, and I’m not familiar with the specific structuring of your notes. While you and your counsel probably worked with your noteholders to create simple, easy-to-understand note agreements, make sure your counsel helps you fully understand the underlying complexities as your notes approach maturity.
OUTCOME 1: EQUITY CONVERSION
You and your noteholders likely had a shared goal when you closed your note financing—your noteholders would convert into preferred equity holders sometime in the next 12-24 months. Now that you’re six months from maturity, how are you going to achieve this shared objective?
There are a few paths that will lead to an equity conversion.
Path 1: Raise a qualified financing round
This is the most common path to a conversion and is likely what you and your noteholders have had in mind since day one. The convertible note vehicle exists to (1) give the company some time and money to grow into this outcome—where an equity valuation will be set for the first time—and (2) reward the noteholders with a sweetened equity allocation relative to new investors (“the discount”) for providing the initial support to get you there.
“Qualified Financing” is a defined in your note documents and will likely take the form of a Seed or Series A equity round. Upon closing, existing notes will convert into preferred equity. In this case, you and your cofounders should be considering four questions:
- Do we want to raise equity capital in the next six months?
Does bringing in equity capital providers with 10x+ return expectations align with your overall company goals and growth strategy?
- What are the implications (pros and cons)? If you don’t want to bring in this form of capital, be honest with yourself and your noteholders and pursue an alternate path.
- How much equity capital do we need to close to trigger our “qualified financing?”
You need to be clear about this amount—it is specific legal language written into your notes and something that you may not have visited lately—as it is your goal for your equity fundraising initiatives. It’s likely in the $500,000-to-$2-million range. When you achieve this level of new equity securities issued, the notes will automatically convert (as spelled out in a “conversion to equity” clause in your promissory note).
- Can we feasibly raise this much capital in the next six months?
Have you been regularly cultivating investor relationships over the last six to twelve months? If not, you better get after it immediately (six months is a tight timeline to start cold). Our CEO Krista Morgan wrote an awesome ebook about how to raise successfully from angel investors—something you may find helpful either way.
If you’re pursuing an angel equity round, you will want to understand whether your note syndicate has the ability and appetite to contribute to a portion of the qualified financing round. If so—great! Reach out to your investors and get commitments. Then, shout it from the rooftops: “Our noteholders are putting an incremental [$x]/[y%] of capital into this round!” and use it as a lure to hook additional investors who can help you close the round.
As you negotiate the terms of your financing round with your current note syndicate, be clear about valuation expectations. Are they looking to set price or are they comfortable riding along with the market? If the latter, do your darndest to have them help you identify and secure a lead investor for the conversion event (or see if you can lock down a lead from existing noteholders).
In order to close your qualified financing round and trigger the conversion, you will likely be on the fundraising path for the next three to six months. The sooner you can get it done the better as the note maturity date provides a clear deadline that investors can use as leverage in their negotiations.
Path 2: Automatic equity conversion without a qualified financing round
In this scenario, the principal plus interest converts into equity as soon as the note matures. This rarely happens automatically and is generally at the noteholders’ discretion with a majority requirement to elect conversion to equity.
If, for whatever reason, it’s not appealing to convert to equity at this point (e.g., you have an attractive qualified financing event on the horizon), your noteholders will likely be amenable to extending the maturity or layering on more convertible capital (from themselves or from new noteholders) to bridge to the qualified financing.
If it is an appealing voluntary conversion (e.g., you can make the case that the company is sufficiently capitalized, self-sustaining, and can continue on a strong growth trajectory without having to take dilution), then a conversion event will require either a valuation negotiation or it is already spelled out in your promissory note and likely just requires a majority of the noteholders to make a conversion happen.
If you do not have language that accounts for an equity conversion of this nature in your promissory note, have a chat with your counsel and founder friends to see how they have handled such a situation after the fact.
Note: Investors have been including this equity conversion clause into increasingly more deals.
Path 3: Change of control
Generally speaking, this is an acquisition of your company. Regardless of whether you’re being bought (you’re attractive) or sold (you’re distressed), a change of control will have financial implications for you and your noteholders that you must consider when structuring your note.
If a change of control event is to occur, you will return capital to your noteholders in one of three ways, only one of which is a conversion to equity:
- Repayment of principal and interest
In this case, you will simply repay your noteholder what he/she invested plus the interest accrued from investment date to change-of-control date. This is extremely founder-friendly and may not leave the best taste in the mouths of some of your earliest supporters.
- Repayment of principal and interest plus premium
In this scenario, noteholders receive their principal and accrued interest plus an additional premium (often called upside participation) for betting on you early. The premium is calculated based on a multiple of the original principal and generally ranges from 1.5x – 3.0x. In my opinion, this is a fair outcome for both the entrepreneur and the investors. A 2-3x return in <24 months is a pretty damn solid return. I’d do that all day.
- Equity Conversion
When the change of control occurs, the loan principal and interest are converted to equity in a fashion similar to what would have occurred had the company raised a qualified financing round. This option can potentially provide the best return on investment to your investors, depending on the purchase price. However, founders should be aware that this may cut into your upside worse than a set premium.
OUTCOME 2: NO EQUITY CONVERSION
Whether by circumstance or choice, your noteholders will not be converting into equity. This means you will either continue to carry this debt on your balance sheet or retire it by paying the principal and accrued interest. In all likelihood, you’ll keep carrying this debt (and possibly more debt) as you continue on your startup journey. Let’s look at a few paths that often lead to this outcome.
Path 1: Extend the maturity date
Convertible note term extensions are very common because (surprise, surprise!) traction generally takes longer to materialize than we all think it will at the outset.
Obviously the notes do not extend automatically, so the onus is on you to proactively communicate with your noteholders rather than just assume everyone is going to be comfortable extending at the last minute. A term extension is normally beneficial to the entrepreneur with a relatively insignificant impact for noteholders, but it is in your best interest to communicate your intentions early and honestly.
While these extensions are extremely common, it’s also common to have unsophisticated and/or unsatisfied noteholders who may not understand nor appreciate the need to extend your notes. Remind your investors that they did not come in looking to be repaid on the note and that you don’t have the capital on hand to do that anyway. You can foster and maintain their support by keeping the lines of communication open and assuring your shareholders that you’re still running hard to get them the returns they are expecting.
Founder tip: You can protect yourself from instances like this by including a “requisite holders” definition in your note stipulating that holders of a majority of the principal amount of notes may take action on behalf of all noteholders. It’s a mitigation tactic that will really make things easier for you and your supportive investors if this situation does arise (as it so often does).
If you do find yourself in a position where you need to extend your notes, I hope two things are the case for you:
- You have noteholders who came in with eyes wide open viewing this as an equity investment and understanding there would be a possibility that they may need to extend to provide additional time cushion to get to a conversion. It’s in your best interest to vet your investors to make sure you bring on people who will not be seriously impacted if you lose their hard-earned cash.
- You have been communicating regularly with your noteholders, working hard to cultivate the relationships, and they feel confident that you’re still on a path to get them a positive return.
Side note: Your noteholders may be comfortable with extending their notes at the last minute, but do not assume this is the case. Not only because you may put yourself in a tough situation you could have avoided, but also because you’re better than that and your investors deserve better than that.
It’s your responsibility as an entrepreneur to maintain an excellent standard for investor relations. Have the tough conversations early and engender their support (and maybe even empathy). Allow your shareholders to take part in the process and you’ll have a much better chance of maintaining their support in the long run. Join our founder/investor relationships webinar on 9/27 to hear from several founders about how they built and maintained long-term successful relationships with their investors.
Path 2: Layer on more notes
In this scenario, you need more than just a little more time—you need more cash (and it is not coming in the form of a qualified financing). This situation calls for bridge financing, which only really makes sense if things are going at least relatively well. Otherwise, it’s throwing good money at a bad situation.
This money will generally come in one of two ways:
- Under the existing note: You and your noteholders will agree to increase the amount that can be raised under the existing note. The same terms will generally apply, but you may have to dangle some incentives (e.g. a deeper discount, no cap increase, higher coupon) if interest is low.
- In a new note: For founders this makes sense if you believe you can achieve better terms than those in your existing note. If you have strong demand for participation, take this path. Otherwise, stick with your original note and avoid the overhead and potential for investors to flex their muscles and push terms on you that are worse than what you already have.
In both of these scenarios, your pitch to new investors will be stronger with existing noteholders supporting in the form of contributing additional capital. Again, I hope you’ve been keeping sound relationships with your existing group of noteholders. You will need their support here.
This path is more work than a simple term extension. In this case you’re in fundraising mode so come prepared, and give yourself enough time to be able to pull it off. Understand the market and be honest with yourself. This may be the path you need to pursue; if so, commit to it fully and start pounding the pavement for investment dollars.
Path 3: Repay and retire the debt
If you have enough capital on hand to repay and retire your debt, you probably want to go ahead with this option. My assumption here is that you have a really special business that is generating and retaining substantial cash flow. Congrats to you!
Maybe you’ve decided that raising more money is not for you. You don’t want to be on a hyper-growth path, and you don’t want to have to answer to investors. Cool, you’re a lifestyle entrepreneur. Explain this to your investors, get their buy-in, and negotiate your note retirement deal. It may be simple—you may be able to just pay them their outstanding note amount plus accrued interest. Or you may have to pay a bit more if the note has a pre-pay penalty written into the terms. This can be a sensitive subject and your early supporters may feel slighted. While you want to be respectful to your investors, at the end of the day you want to do what is best for the business. I encourage you to act reasonably and fair and think long-term about your reputation as you approach the subject with your noteholders.
This can be a convoluted topic, and I’ve presented a lot of information here, but it should help to guide you as you take the next steps toward your desired outcome.
You’ll hear from others that convertible notes are simple, quick, and clean. And, for the most part, they are (ish). However they still have a degree of complexity. They are, after all, legal documents that have major implications for your business and include financial terms you may not be familiar with. You’ll likely need expert guidance from a lawyer.
As with every scenario, make sure you understand how your note reads, lean upon your counsel, and strive to use standardized, market-tested templates. And, please, do not make blind assumptions; attention to detail matters here.
If you find yourself in a situation where you can use some bridge capital beyond your convertible note or you just want to talk early stage finance, I’m happy to chat. Reach me at firstname.lastname@example.org or (303) 475-4331.
A few additional resources:
- Seed Financing Report (2015) — A comprehensive report on the early stage debt/equity financing market trends from Silicon Legal Strategy
- Convertible Debt FAQ — The partners at Cooley have done A LOT of convertible notes. Here’s SF Partner, Peter Werner’s, $.02.
- Techstars Convertible Debt Bridge Term Sheet — Simple, 3-page note with key terms highlighted and outlined.
- Safe (convertible note alternative from yCombinator)