The most popular structure for early stage financing is a startup company’s issuance of convertible notes in exchange for its first significant capital infusion.
Convertible notes are often used by angel investors who are willing to invest in high risk companies before they can show any profit. An explicit valuation of the company isn’t established prior to investment.
Startups tend to lack the projected cash flow or other resources to have a realistic shot at repaying their debt at maturity. Although the convertible note structure may actually be one of the more useful innovations of the private capital markets, it is worth noting that this was not always the case. But for the fact that investors are (almost) always well aware of this situation, convertible note financing sounds like the classic Ponzi scheme.
A company would issue additional notes at a later date, and repay the prior notes with those proceeds. The process is repeated until the scheme is discovered.
Because of this, convertible note financing isn’t the best plan of action.
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Here’s the problem:
Angel investor (AI) invests in convertible notes of Company X that convert automatically into Company X’s Series A financing round, in which preferred stock will be sold in exchange for investment. One year later, Company X negotiates a Series A financing round with an institutional investor (venture capital, or VC) and after reviewing Company X’s capital structure – including the convertible notes – VC makes a proposal.
They will purchase Series A Preferred Stock at the price and valuation they agreed with Company X. However, at the closing of their financing, all of the convertible notes will convert into a newly created Series A-1 Preferred Stock. The Series A-1 Preferred Stock will be sold at the same price per share as our Series A, but it will be junior to the Series A. Oh, and the cap and discount contained in the convertible notes will have to be waived.
So much for the grand bargain!
This issue is not unique to convertible note financing. The problem can arise in any situation where the introduction of a third party can inconsistently alter an existing contractual relationship.
Simply put, entrepreneurs are not willing to sell something at today’s price that they’re sure will be worth many times as much tomorrow or the next day.
It is a critical underpinning to this negotiation that neither party believes the other party’s assessment to be incorrect. Entrepreneurs are not debating that their company may only justify a low valuation today – it would be irrational to sell equity based on the current pricing. This is, in a sense, a form of “reverse inside information,” where, instead of trying to buy a stock because the buyer “knows” something, the seller refuses to sell stock for a similar reason.
Of equal importance, angel investors may well share the views of the entrepreneurs regarding the short-term potential for the value of the company. However, the investors may not share this view sufficiently to agree to the “projected” valuation at the current time. They are willing to forego requiring that entrepreneurs sell them equity at its current market price, in exchange for receiving the right to purchase equity at a predetermined discount to its future market price.
There are as many historical anecdotes about company X or founder Y who sold 10% of what became a multi-billion dollar business for, say, $50,000, as there are about early stage investors who have built sterling and enduring (even if never quite replicated) reputations for being exactly “that” investor.
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Still, the “grand bargain” is based on a bit of a logical fallacy. The facts that Company X could be worth $25 million dollars one year from now, but is only worth $3 million dollars today are not inconsistent. Both numbers could accurately reflect the fair market values of the same company at two different (even if not particularly remote) points in time.
In fact, an angel investor could note that a big reason that Company X might be worth so much more in a year or less is its ability to raise the necessary capital today – at whatever price it can command – to execute on its business plan. If entrepreneurs took the same position with later stage investors that they did with angel investors (e.g., “We will not set a valuation for our Series B round, but will give you a discount on Series C”), private capital markets would sputter.
The convertible note structure affords both parties the benefit of its bargain. By issuing debt instead of equity securities, startups can raise capital yet defer establishing a valuation for the company until the business has become more mature.
By incorporating the familiar conversion discount and cap mechanisms into the terms of convertible notes, angel investors can assure themselves of a meaningful discount to the equity valuation that they expect an institutional investor will pay at a later point.
Of secondary, but also significant importance to angel investors, the convertible note structure allows angel investors to invest directly alongside institutional investors while risking more modest amounts of capital. Had these same investors waited until the institutional financing round, they may have found themselves either subject to much higher investment minimums or excluded altogether by the institutional
Without having verified this, one of the more popular such anecdotes that I have heard involves a young Bill Gates offering a 5% interest in an early Microsoft for $25,000.
Of course, had these same investors waited to deploy their capital, the company may never have gotten to the point of being able to raise such an institutional financing round.
What the angel investor missed is that there was “a third party” in the original agreement with Company X, namely, the the unidentified future Series A investor. Company X is not in breach of the convertible note terms, as it is not requiring the terms proposed by the VC. VC is not a party to the convertible note agreements, and thus has no legal obligation to “honor” the deal that would apply upon conversion of the notes.
As a legal matter, VC is essentially “asking” for the original parties to the convertible note financing to alter their arrangement by conditioning its agreement to invest on this accommodation.
What To Do?
I have thought about this problem from a legal perspective, and I don’t love most of the likely answers. One argument is that VC’s proposal amounts to tortious interference with angel investor’s and Company X’s contractual arrangement. I have yet to find precedent supporting such a claim.
A similar argument might be that VC and Company X “conspired” in crafting VC’s proposal. The angel investor could point out that VC’s proposal economically benefits Company X (or at least its founders) – through the avoided dilution from the application of the conversion discount or cap – but the benefit to the founders comes at no corresponding economic cost to VC.
This could be a challenging case for the angel investor. I am again unaware of any direct precedent, but would look for guidance by analogy at Delaware case law regarding “wash out” financing transactions. Such guidance, to the extent applicable, would be discouraging.
Still, courts could rule, as a matter of public policy, that the agreement reached between the angel investor and Company X must be enforced in the context of a transaction with VC. Public policy concerns are legitimate justifications for the exercise of a court’s equitable powers.
The remedy “at law” would be money damages rather than the specific enforcement of the cap or discount. The court could rule that Company X cannot avoid its unambiguous contractual agreement because of “subsequent developments.” This ruling would be made on the grounds that if such an excuse were allowable, the very enforce-ability of contracts would become uncertain. I don’t love the idea of leaving the issue to a court’s equitable powers, and I don’t expect that judges would love the idea either.
A market response may ultimately be the better approach. While it would be difficult to hold particular companies or entrepreneurs accountable for a “Princess Di Problem,” over time, the angel investor community might migrate away from the convertible note structure in favor of purchasing equity securities from the outset (i.e., going back to where this market started).
Doing so would impose the attendant cost to entrepreneurs of establishing an equity valuation for the company at what they consider too early a stage.
For example, if entrepreneurs formed the view that the cost of dilution from the lower priced initial equity financing was greater than the benefit of avoiding the application of the discount or cap at the time of a Series A financing, then they might align themselves with AI at the time of the Series A financing.
This approach might work well if in point of fact, the VC needed (or believed that it needed) Company X’s tacit approval to make such a proposal to the angel investor. The angel investor and entrepreneurial communities might also make collective note of which institutional investors were most likely to attempt such a maneuver – thus rewarding the good actors and snubbing the bad ones.
In a competitive market, with more money chasing fewer good investments, a market response may well produce a more concerted, efficient result than a judicial (not to mention legislative) campaign.
