Convertible notes seem to be all the rage for pre-revenue tech startups these days. Convertible notes (aka convertible debt or convertible loans) are a financing mechanism whereby a company raises debt capital from investors at time zero, with the ability for the investor to convert this debt into equity at a later date at a fixed conversion ratio.
This funding tool is probably most prominent for early-stage (i.e. pre-revenue) tech companies who often use convertible notes to delay a discussion on valuation until a later date, when the company has firm metrics to evaluate. While the mechanics behind convertible notes vary, here is a typical scenario: a company raises $1 million in convertible debt, which has the right to convert to equity at a 25% discount to the valuation of the next financing round. So if the next round raises at a $10 million valuation, the note holder will convert as if the valuation was $7.5 million.
Often, there is an interest rate attached to the note which is typically paid-in-kind, that is, the accumulated interest will also be converted to equity when the rest of the note converts.
I’ve worked with convertible notes in a variety of ways: as an investor, with companies on our current marketplace, and as an entrepreneur. I don’t think they make sense for every business—and there are strong arguments for why some investors are cool on them. That said, here are three reasons why I think convertible notes sometimes make sense for early-stage consumer companies.
Helps Defer Valuation Conversations
The most common reason we see early-stage consumer transactions fall apart is over valuation gaps between companies and investors.
Entrepreneurs think their company is worth more than potential investors do and with a straight equity investment there is often no way to bridge this gap. However, convertible notes allow this conversation to be deferred until the next round of financing. This allows investors to have independent affirmation, often from an institutional investor, of their investment at a discount (if successful) and entrepreneurs to avoid dilution at a valuation they consider too low.
In early stage consumer, good valuation comparables are very tough to come by due to the historical inefficiency of the market. Using multiples from public companies like Clorox or Pepsi doesn’t make sense, and the private deals that are reported are often those with outrageous sale prices (i.e. vitaminwater). In tech, early stage valuations are much more standardized. In consumer, because the market is much less efficient, valuations are often more varied.
We're working on this at CircleUp. We recently launched a new tool to help entrepreneurs and investors gain more visibility into early-stage valuations, among other key metrics. Learn more about it here.
Deferring valuation often helps get a deal done. There is a chance the investor isn’t happy with the next round’s valuation. And a chance the company isn’t. But the key here is that both sides want a deal to be done—or else they wouldn’t be talking—and it’s a shame when valuation alone prevents a deal from being done.
The Consumer Entrepreneur Gets Penalized for Revenue
One of the great things about being pre-revenue is that it is impossible for potential investors to put concrete multiples on your business — 10x of zero is zero. You sell based on a dream. While some VCs or angels reassure themselves of the soundness of their investment by relying on user-based metrics, this is often more noise than signal—an exercise in false precision. You may have one million users today when you give away your product, but what happens when you charge $9.99 per month?
The attrition can break the most promising young business. Consumer companies on the other hand are revenue positive very early on, as the only way to build a brand is through retail distribution, which brings revenue with it. However, the downside to having revenue is that investors can apply a multiple to it, even when the multiple doesn’t fairly capture growth rate or company stage.
Many investors would gasp at a 5x revenue multiple for a consumer company, even if that means a $5 million valuation for a company with $1 million in revenue. Contrast this with tech where you have companies that raise eight-figure rounds with no revenue, partly because there are no concrete financial metrics to ground the discussion. There are other reasons why tech companies often get higher valuations, but the point here is that consumer entrepreneurs essentially get penalized for generating revenue.
For early stage consumer companies with some revenue, convertible notes can make sense because they allow them to raise much needed capital without being penalized for de minimis revenue — and they allow investors to sleep soundly knowing they didn’t pay an outrageous valuation for a company.
Convertible notes are especially useful for high-growth consumer companies. Here's an example. A consumer company hit $2M in revenue last year. It's March of this year and its run-rate revenue implies $5 million. This can create a struggle between the entrepreneur who wants to be valued on forward revenue; and the investor who only wants to give the entrepreneur credit for actual financial results. Convertible notes allow both sides to hedge—the entrepreneur doesn’t have to give up the value of built in growth and the investor doesn’t have to pay for revenue that hasn’t been delivered yet.
A convertible note is not a perfect solution, but I’ve seen one too many deals fall apart because the entrepreneur wants a forward valuation and the investor is only willing to pay for historical performance.
While the three main reasons presented above are all pros to using convertible notes in consumer, there are also downsides to these instruments. From an angel investor’s standpoint, they are delivering debt returns for someone who is committing equity capital at a very risky stage in a company’s life cycle. Furthermore, the notion that they have the security of a debt instrument is usually a fallacy—rarely is there any liquidation value when an early-stage company fails.
This post also doesn’t cover all of the important aspects a company or investor should think about when considering convertible notes. Valuation caps are an important way investors can limit their “downside” (i.e. a high valuation in the next round). What if the company may not have to raise another round? In that case the debt-like features of a convertible note are much less attractive for an investor than traditional equity. You can also argue convertible notes split the incentives of the investor and entrepreneur — never a good thing. These, and other considerations, should be discussed with your lawyer before thinking about investing in a convertible note or using it as an entrepreneur.
While convertible debt has its pros and cons, I think it’s a great tool for early-stage consumer investors and entrepreneurs. Most important, for investors and entrepreneurs, is to realize early-stage investing is a high risk, illiquid asset class regardless of the security you’re investing in, be it equity or a convertible.
And perhaps most importantly, diversify.