Convertible notes can be a great source to get a startup off the ground. Convertible notes are debt, or loans, that convert to equity at a later date. And that later date brings up an issue: what happens to that convertible note if a startup fails?
When a startup fails, the company typically has run out of money. The owner of a convertible note may get nothing, or at best may only receive pennies on the dollar. You also may be able to write off your loss.
There are a number of factors that go into determining what happens with a convertible note. Whether you are an entrepreneur or an investor, it is in your best interest to negotiate these terms up front.
Three key factors are:
- If a guarantee was given to the owner of the note.
- If a guarantee was given to any other investors.
- Whether the company has any equity or funds remaining.
Not all convertible notes are created equally. In the following sections, we’ll discuss what exactly a convertible note is, what the advantages and disadvantages are, what features to look for in a convertible note, and what to do if you hold a convertible note on a startup that failed.
What is a Convertible Note and How Does it Work?
A note is a loan. A convertible note is a loan that changes, converts, to equity. There are many variations on a convertible note, but generally, they are:
- Shorter-term investments – the investor is not interested in the loan or having the loan repaid. Instead, the investor is most interested in the conversion, they want the equity investment.
- Issued during the first rounds of fundraising. This is because at this point establishing the value of a company is very difficult, arbitrary really, and getting the valuation wrong is bad for both the investor and the startup. So the note is a way of putting off the valuation.
- Is converted into stock ownership in lieu of being paid back with interest, usually, interest accrues and becomes a part of the conversion rather than a payout to investors. Again, this is because investors are mostly interested in a long term equity investment.
- Is sometimes called convertible debt or convertible bond – these are different names for the same thing.
How a Convertible Note Generally Works
The concept is very simple:
And investor puts x amount into the company, say 100,000, by investing in a convertible note. That note pays interest, lets say 8% and there is a rule regarding conversion. At some point in the future the value of the note, which is the investment + accrued interest, will become equity.
That generally happens when there is a “priced round,” someone bigger with more money invests in the company and determines a valuation. At that point the convertible note becomes equity at the lower of the valuation or the valuation cap determined in the note.
That is the way a convertible note is supposed to work. So, the big question is what happens when a company fails.
What to Do if You Invested and the Company Fails
Investing in early stage companies is extremely risky. When we are positive, absolutely convinced in every way that a company will return 30x our money we are wrong. Even then, statistically, there is a 50% chance that the company will fail. That is the nature of early stage ventures.
So what happens. Well, really, in most cases as an investor you are out of luck. Sure there may be some recourse or you may be able to sell assets to get a few pennies back. But mostly, you take the hit and move on. Because the reality is, no matter how many terms and restrictions you have written into the note getting money from a failed startup is like squeezing blood from a stone.
That’s the nature of investing in startups.
All may not be lost. There are a few options, from recouping a portion of your loss by writing it off on your taxes, to taking control of the company (depending on how your convertible note was set up). If you are interested in the latter, consult with a legal team.
The most common scenario is to take the hit and write it off.
If you are investing in startups, you probably have (or should have) an accountant! So, don’t take any of this as advice… but here is generally what to consider:
- Determine if it’s a short-term loss or long-term loss
- Short-term loss: note was held for less than one year
- Long-term loss: note was held for more than one year
- Determine the amount of your capital loss
- If the note did not convert, it is the amount of the note
- If the note did convert, you will need to determine the cost basis of the stock and multiply it by the number of shares you were owned.
- Fill out form 8949 and Schedule D on your taxes.
- An individual can claim up to a $1500 loss each year, married filing jointly may claim up to $3000. But the amount leftover may be rolled over each year until the entire loss has been used.
Factors to Consider Before Issuing a Convertible Note
- Most convertible notes do not pay interest, but interest does accrue.
- The accrued interest increases the number of shares at conversion
- Maturity Date
- This is the date the repayment is due
- As mentioned above, it’s beneficial to require the note to convert at maturity
- Conversion Discount
- This is a discount to the investor of price per share once company is valued
Pros and Cons of Convertible Notes
- Immediate funding
- No waiting for a company to be valued.
- It can take only a few days to close on a convertible note, whereas issuing stock is a much longer process.
- The difference: as fast as one day for a convertible note, as much as three weeks for issuing stock
- One of the reasons it takes longer to issue stock is the amount of legal work involved: negotiating terms, creating the legal documents, etc.
- Convertible notes only require a few pages of documents.
- Lower Cost
- With fewer negotiations and documents, the legal fees involved in a convertible note are much lower.
- Convertible note: as little as $1500 in fees. Stock issuance: up to $30,000
- Early stage companies burn through cash
- When a company is starting from scratch, they go through a lot of cash. Meanwhile, they are bringing in very little income or maybe no income at all.
- This means a strong possibility that if they fail, they fail completely broke. If they have nothing left, then their investors will not be repaid
- Not always guaranteed
- If the startup cannot or will not do a second round of fundraising, then the note does not convert into stock. (unless a provision is included setting a maturity date.)
- If the company is not failing, but not earning enough to pay back investors (if the note does not convert at maturity), there can be a deadlock that can lasts years.
- Investor and Startup interests may clash
- If the convertible note’s provisions are not written out correctly, the investor and startup interests may clash
- It would benefit the startup to maximize valuation of the company
- It would benefit the investor to minimize the valuation of the company