Convertible notes are a very common startup financing method. Convertible notes contain a maturity date provision at which point the notes are to be repaid with interest. This is usually set at 18-24 months after the first convertible note investment.
However, repayment of the notes upon the maturity date is usually not a great scenario for the company or the investors. First, the startup likely does not have the aggregate principal plus interest available to repay the convertible note investors. Second, the investors weren’t in the startup investment for the 2-8% interest rate. In reality, from the outset, neither startup nor investor is looking for repayment upon the maturity date. Both startup an investor are hoping that the convertible notes will convert at the next equity round.
So what happens when the maturity date comes around and the startup cannot pay back the notes? Is the startup totally screwed because the note investors are going to foreclose upon the startup? Well, in practice this just isn’t very likely to happen — what are the investors really going to foreclose on? And how much is that going to cost them to do so (including time)? Thus because both startup and investor usually have some leverage, generally a maturity date extension is agreed to at such a time.
But because of this fear of being foreclosed on, one school of thought is that the convertible notes should automatically convert into equity upon the maturity date, and therefore convertible notes should be drafted with a maturity date automatic conversion provision (or worst case, such conversion at the maturity date is at the option of the investors).
In practice, however, this is usually a mistake as such a maturity date automatic conversion term is likely not a company-favorable term….and therefore such a term favors the investors. So, if you are a startup, don’t agree to a convertible note maturity date conversion provision for the following reasons:
Extra Negotiation and the Punitive Pre-Money Valuation
First, the maturity date conversion term will add an extra layer of negotiation to the convertible note process. One of the desirable characteristics of the convertible note is that it is a quick and easy way in which to raise capital, and adding this term will prolong the process. This added term opens the door for important questions that will have to be answered, including:
(1) into which kind of stock will the notes convert at the maturity date?
Most investors do not want to receive common stock, ever, so if you agree to a maturity date conversion provision you’ll have to come up with some type of preferred stock the notes would convert into at the maturity date. Most times this can be expressed as some type of standard seed round financing docs (such as seriesseed.com), but other times you’ll end up wasting time negotiating both convertible note terms AND a preferred equity round terms at the same time.
(2) at what pre-money valuation should the notes convert at the maturity date?
There is an unfortunate (and prevalent) view from some investors that a startup not having had an equity financing prior to the maturity date of their convertible notes is some type of “failure” of the company or signal that the company is not doing well. And as such, they feel that if the note hasn’t converted prior to the maturity date, then the investors should be able to convert at some type of punitively low pre-money valuation (i.e., much lower than the price cap which would be the max pre-money valuation upon the next equity round).
This view is incorrect as many times a startup may simply not need to obtain additional financing prior to the maturity date and/or maybe the startup is waiting for additional development or sales in order to secure a better pre-money valuation at its next large equity round. Thus, there are plenty of reasons that a startup could reach the maturity date on its convertible notes and this occurrence is not indicative of “failure”. But this doesn’t stop investors from trying to get a punitively lower pre-money valuation relative to an agreed-to price cap.
Side Note — Incentive (Mis)Alignment has come Full Circle!!!
Interestingly enough, it seems that we have come full circle on convertible note startup-investor alignment issues. Originally, the price cap was introduced because convertible note investors had no incentive (in theory) to assist their portfolio companies with convertible notes, as their help would only increase the pre-money of the eventual equity financing, thus giving the convertible note investor a lower percentage of the company upon their conversion at the higher pre-money (even factoring in their applicable discount).
Now, if investors are getting a much lower price cap upon a maturity date conversion than what they would receive at the next equity financing (price cap), this tends to provide investors with no incentive, again, to assist the startup towards obtaining a large financing and automatic conversion, and instead converting at the punitive pre-money valuation at the maturity date and receive a much higher percentage of the company.
It also follows that, if the maturity date pre-money conversion is somewhat close to the price cap and you’ve agreed to convert into something like the Series Seed preferred stock upon the maturity date…then why not just do a Series Seed equity round at that the maturity date pre-money valuation and skip the convertible note?
Increased Transaction Costs upon Conversion
The automatic maturity date conversion will end up costing the company a lot of money. The main reason being is that if the notes convert into some kind of preferred stock, be it series seed or series aa, it ends up expensive and time consuming for the company, as the entire process, from convertible note to maturity date preferred stock conversion, would end up eventually costing the company more than if it had just done a preferred equity round from the beginning.
Automatic conversion upon the maturity date of a convertible note is a bad idea and not in the best interests of the company. Luckily, there are alternative solutions to this maturity date problem. The simplest solution is simply an extension of the maturity date. While this does require the consent of the investors, or at least a majority of the investors, hopefully they will see that it is actually in their best interests. The maturity date extension executed most, if not all, of the time. Of course, there’s always the one-off situation where convertible note investors act irrationally and sought to foreclose, but the startup’s mistake was likely the investors they chose, not the structure.