Convertible Notes: A Fight for Another Day

Convertible Notes: A Fight for Another Day

 By Danielle O’Rourke – February 9, 2018

I have a quick request before I get to today’s topic:

I’ve been trying to identify the best way I can personally help create a more diverse business ecosystem. I believe I can be much more effective at helping the next generation of financial talent or entrepreneurs better position themselves for success within the realities of the world we live in vs. focusing on ways to eradicate existing ingrained bias. (That doesn’t mean I don’t support initiatives regarding the latter).

To that end, has anyone read a good study that analyzes the way entrepreneurs of different gender, ethnicity, education, social economic circumstances, etc. approach capital raising? I’d be curious to see if there are any differences in the number of investors they approach, the types of investor they approach, how they get introduced to investors, their asks, the general tone of their pitches, how they rate their own strengths/weaknesses as leaders, etc. etc. etc.

I’ve seen interesting studies on how investors approach minority-led teams vs. male-led teams during pitches, but I’ve seen almost nothing discussing the opposite side of the table.

If you have any data or statistics, please send me a link.

Now, to the newsletter:

Topic of the Week: Convertible Notes, A Fight for Another Day

A few months ago I wrote about a mythical creature called “non-dilutive capital.” If you missed it, here is the original post.

In that post, I ended with the following statement:

“The question business owners need to ask themselves is this: Based on the current state and risk profile of my business, what type of capital will be less dilutive to me?”

I’ve seen one specific example of this question 8 times in the last week. It’s when the owner of a young, growing business wants to raise capital and is deciding between raising a convertible note or a priced round.

If you’re not familiar with the nuances of convertible notes, here’s a quick primer.

It’s been my experience that many entrepreneurs view convertible notes as a quicker, easier form of financing than a priced round. Here are a few of the most commonly cited reasons I hear:

1) I don’t have to assign a valuation to the business today.

2) I’m not diluting the existing cap table today.

3) I don’t need to amend management provisions within my operating agreement today.

It’s just easier, TODAY.

By raising a convertible note, you substitute short-term headaches and hard decisions for long-term uncertainty.

For example, what if you struggle to raise another round of funding, the note hits maturity, and you don’t have the cash to pay it back?

Hopefully, your note holders will agree to amend the note maturity date, but what if they don’t? What if they disagree with the way you’ve been running the business and to amend it, they insist on you stepping down. Or, what if they refuse to amend it and force a liquidation of the business?

While this is an extreme scenario, it happens and is one example of the very real type of risk you punt down the road when you take on convertible debt.

Every entrepreneur deciding between a convertible note and priced round needs to ask themselves this question: “Is the cost of raising a priced equity round today greater than the long-term uncertainty associated with raising a convertible note?”

I could probably write 10 more pages on the nuance around this decisions, but here’s my rule of thumb:

If you don’t have a high degree of visibility towards your next round of financing or the ability to pay back the note, it’s tough for me to see a situation where a convertible note makes sense for a business owner.

Have a great weekend everyone!


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