With the recent volatility in the market, we expect the conversion of convertible notes in a tighter Series A market environment to get a little more interesting. Not that the conversion road hasn’t been littered with lurid tales already…
Many in the market today believe startup valuations will go down in 2016, and that means tougher terms for later rounds. If you have invested in a startup with a convertible note round or are a founder who raised with convertible notes, it is imperative to focus on how your notes get converted when (ahem, if) a new round of financing is raised.
At Promus Ventures, we have invested in a lot of convertible note rounds. We have been privileged to invest in fantastic teams over the last three years (51 at latest count) and our first money into a startup is almost exclusively at the seed round (76% of the time). Of these seed round investments, 64% were done using Convertible Notes and 60% of these startups that raised notes to date have converted their note rounds into Series A preferred equity rounds or were acquired.
We have seen all kinds of fireworks at the Series A when notes convert. This results from note rounds that are loosely written (in theory) to give founding teams the ability to negotiate the priced round however they choose. We have seen notes that do not state how they are converting (pre-money or post-money) and often have multiple caps to boot.
Founders end up getting into a mess mostly because they were unaware of these issues when doing their note round, and then later want to take care of both early and new investor expectations at the Series A but can’t (trust me when I say it can be a mess). Instead of what should have been a vanilla conversion from notes to preferred equity, we have seen (among other things):
- Convertible Notes get entirely converted to common (instead of entirely preferred)
- Notes get converted to a blend of preferred (to the cap) and common (for any higher valuation above the cap)\
- Notes price just under the Series A equity per share price even though the Series A valuation is far higher than note cap (due to denominator share shenanigans)
- Founders requiring early investors to sign an option agreement giving the Series A lead the ability to buy their converted preferred shares at the last round financing “at any time in the future with no expiration.” If an investor didn’t sign, the notes were going to be paid back (with interest, thank you).
- Founders paying back some investors’ convertible notes but pricing others (even though later notes were raised at significantly higher multiples to their cap).
- Investors who had their notes ripped up and thrown away completely.
In one instance, a founder in which we had invested had no idea until too late in the game that the lead was manipulating the denominator calculation of equity to punish early investors until we asked the founder why he was allowing this in the docs. His well-respected lawyers didn’t even alert him that the lead’s conversion formula was way out of market. Strangely enough, we were the only ones on a lengthy cap table who picked up on this issue.
Most winning founding teams are smart about convertible note conversions and are clear when writing their convertible note round language. As a firm, we have for years protected ourselves and founders against future issues by together talking through these issues early on and inserting appropriate and precise language in convertible note rounds where possible.
Convertible notes can open up all kinds of future tomfoolery if you’re not careful and in today’s new environment, things could get nutty. A good soldier wouldn’t leave a comrade behind in battle, so founders should be prudent when writing and converting early notes by moving slowly and methodically to ensure a fair process. These simple actions will return great dividends back to the team and company well in the future.
Recipients of this post are not to construe it as investment, legal, or tax advice, and it is not intended to provide the basis for any evaluation of an investment in any fund. Prospective investors should consult with their own legal, investment, tax, accounting, and other advisors to determine the potential benefits, burdens, and risks associated with making an investment in any fund.
