Cash-is-KingThis is the second of three articles on Convertible Notes for founding entrepreneurs. Convertible Notes Part One: The Basics defined what a Convertible Note is and compared it to Preferred Stock. This article will examine how negotiations arrive at Convertible Notes.

Founders have several options to raise money. Their options depend largely on how attractive their company is.

Loans and Bonds

On one end of the spectrum, founders can negotiate a loan from a bank or sell bonds to the market. Loans and bonds attract investors with lower risk tolerance. Since early-stage companies have high risk, loans and bonds can be harder to find. The costs are both payable interest and repayble principle.

The benefit is that founders retain all rights to control of the company and after-interest profits. Founders of a company whose value exceeds its need for money may make loans and bonds their first choice.

Common Stock

On the other end of the spectrum, founders can sell part of their ownership equity through common stock. Ownership attracts investors that are more risk-tolerant. Since early-stage companies have high risk, founders often have an easier time finding money. The cost is some loss of long-term profits and control of the company.

Founders avoid paying interest or repaying the principle. Founders of a company whose need for money exceeds its value may be required to make common stock their first choice.

The Technical Problem of Valuation

In reality, measuring value is hard to do in the early stage. Both founders and investors have little information.

From a founder’s perspective, lack of information makes it difficult to argue that loans and bonds are safe for investors. Lack of information also makes it difficult to argue that common stock will pay off in the long-term for investors. Too many startups fail and go bankrupt for an investor to feel comfortable with either option. Until more information can be gained, both founders and investors find themselves between a rock and a hard place.

The Middle Ground of Preferred Stock

To avoid the two extremes, founders can sell preferred stock. Because each extreme is difficult to justify, this compromise is attractive to many investors. Many founders also feel comfortable with the compromise.

Preferred stock has greater rights to dividends and first rights to liquidation value, making it safer for investors than common stock. In exchange for this safety, preferred stock gives up its rights to equity. While preferred stock often also gives up control, this is a sticking point for early-stage investors who require special rights be added to the preferred stock. These special rights take the form of a board seat and veto rights to some actions like company sale.

The Practical Problems of Valuation

Even in situations that provide enough information for a reliable technical valuation, the valuation process is costly and time consuming. Founders have little time or funds for either without distracting from the all-important task of keeping the business afloat. The worst case scenario is that the company stalls and fails as their founders struggle to gather that information.

Only slightly better is that the founders sell too early and too cheaply, losing the long-term payoff they risked so much to achieve. Selling preferred stock instead of common stock does not substantially decrease this risk. Since preferred stock has greater rights to dividends, selling too early and too cheaply means greater dividend loss. While preferred stock has lower rights to long-term equity value, it is still equity. This means it will impact future valuations, potentially losing founders (and investors) money in future funding rounds.

Other problems with early valuation exist too. When the IRS disagrees with the valuation, taxes can be higher than expected or justified. Flexibility with employee-incentivizing stock grants may be lost too. Competing investors can deadlock, each waiting for the other to complete their valuation before finalizing their own.

The Solution of a Convertible Note

A convertible note is a loan that matures into preferred stock. Because it is a loan, convertible notes avoid the practical problems of early valuation. The time is decreased from weeks to hours. The cost is decreased from tens of thousands to a few thousand. Valuation disagreements with the IRS are avoided. Stock option grants remain uncomplicated. Most importantly, founders also delay the time at which they set the valuation of their company; this helps them avoid the risk of selling too early and too cheaply.

In the short-term, founders benefit even more from the flexibility of the convertible note. Because formal valuation is avoided, founders can make different deals with different investors. This gives them the ability to incentivize quicker investors, therefore breaking the deadlock. Preferred stock may be better for investors, but a convertible note is better for founders.

The Key Negotiation Terms

Investors are open to purchasing convertible notes because their convertible notes eventually mature into preferred stock, so investors seeking the middle option eventually get their ideal compromise of short-term and long-term risk. Investors are also open to convertible notes because they recognize the practical and technical benefits.

Still, accepting a convertible note instead of preferred stock means losing their immediate position of negotiating power. Investors accept convertible notes instead of requiring preferred stock because they are offered three incentives: a cap, a discount, and interest.

A cap is a limit on how the eventual common stock valuation affects convertible note’s preferred stock. When the eventual valuation exceeds the cap, the investors get a discount on their converted equity. As the valuation increases, the discount becomes more profitable. Founders incentivize investors by offering a lower cap to the first investors. The median valuation cap was $4 million in 2010 and $7.5 million in 2011.

Discounts are offered to investors to hedge against the risk of the company not being valued above the cap. In case of a below-cap evaluation, the investor will get a discount on their stock purchase. This discount ranges from 10% to 35%. Founders incentivize investors by offering a higher discount to the first investors.

Because valuation may happen—or not happen—at any time, interest is also offered to the investor. Typically this is in the 5% to 10% range. If paying interest is surprising, note that the principle of the loan is never repaid—it merely converts. Paying interest encourages the founders to reach the valuation soon and compensates the investor for the interim time. Founders incentivize investors by offering a higher interest rate.

Why Everyone Wins

Founders and investors are a peculiar pairing, facing the unavoidable problem of dual roles. On one hand, founders are vendors to investing purchasers. On the other hand, founders and investors are partners in the company. However inevitable, these competing interests can be problematic. When either side succeeds in taking advantage of the other in the valuation sale, the long-term partnership can be damaged. Putting the partnership above self-interest has limits too; no one wants to be left without appropriate compensation.

Aligning these interests is how everyone wins. Where preferred stock requires valuation first and partnership second, convertible notes delay valuation until the partnership has already had a chance to build the company. Putting partnership first aligns founders and investors.

The cap remains the key term. A cap that is too high de-incentivizes investors. A cap that is too low de-incentivizes founders. An appropriate cap lets everyone win.

Next Steps

The difficulties of evaluating these choices for each situation require the expertise of a CFO. Companies without a full time CFO should consider hiring a part time CFO. While hiring a temporary CFO is an option, companies looking for investor funding benefit strongly from a permanent solution. An outsourced CFO is the most affordable way to gain long-term expert advice without the high cost of an expensive internal officer.

Please speak with Preferred CFO for any additional questions.