Convertible notes can be a great source to get a startup off the ground, but you may be concerned about what happens to that convertible note if a startup fails. Creating your first startup is exciting but scary. Investing in a startup can be just as thrilling. But there are so many unknowns, including questions about funding.
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 may be able to write off your loss.
Factors affecting repayment include:
- 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 convertible note:
- Is a short-term loan
- Is usually issued during the first round of fundraising
- Is converted into stock ownership in lieu of being paid back with interest
- Is sometimes called convertible debt or convertible bond
Terms to Understand:
- Fundraising rounds.
- Startups often start with “seed money” from friends, family, and venture capitalists. This is where convertible notes are often used because the company has not been valued yet.
- Companies who have stuck around long enough to show serious growth usually move on to Series ‘A’ fundraising. The company is now proven enough to be valued, and stocks can be issued.
- Valuing a company.
- This is a process of determining what a company or business is worth.
- This helps investors know how much each individual stock is worth and whether they are interested in investing.
- Owning stock in a company gives you part ownership, which provides you with more power than just loaning money, which will be paid back with interest.
- Exit Vs. Fail
- Exit: a company is aware they are not able to continue because of a lack of income. The company is not broke, and they make a plan to exit from the market.
- Fail: a business has run out of money and has no recovery or exit plan.
- Tax Write-Off
- The dollar amount of a loss you can deduct from your income on your taxes will lower your tax burden for that year.
- Sometimes you can carry over a loss for several years.
- Discussed in more detail in following sections.
- If the note did not include any language providing a guarantee to the investor, it is “unsecured” debt, which means there was no collateral against the debt.
- Suppose another investor had a guarantee written into their note. In that case, they may be first in line to recoup any money available to repay the company’s debts, meaning you are less likely to receive any repayment.
Convertible notes are short-term because they are most often used in the first round of fundraising. When a company is brand-new, or even just an idea in their creator’s mind, it’s very difficult to determine the company’s value.
So, the convertible note is a promise to turn the loan into shares of stock during the next round of fundraising, after the company has been established and can be valued.
What to Do if You Invested and the Company Fails
We’ve all heard the statistics and know that most new businesses fail in their first year. Sometimes, you just have to take the hit and move on. 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! For those who don’t, or are just curious how it works, the process is roughly listed below. Disclaimer: this should not be taken as tax advice, and consulting an accountant is recommended.
- 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 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
- They may accrue interest which increases 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