Convertible notes are a very common startup financing method. They typically include a maturity date, at which point the notes are, in theory, due and payable with interest. Convertible note maturity is often set 18 to 24 months after the first note investment.
In practice, repayment at maturity is usually not a great outcome for the company or the investors. The startup rarely has the cash to repay principal plus interest, and most investors did not invest for a 2 to 8% interest return. From the outset, both the startup and the investors are usually expecting the notes to convert in the next priced equity round.
So what happens when the convertible note maturity date arrives and the startup cannot repay the notes? Is the startup in trouble because note investors might try to foreclose? In practice, that is uncommon. Investors still have to ask what they would actually foreclose on, and what it would cost in time and legal fees. Because both sides usually have leverage, the most common outcome is a negotiated extension of the maturity date.
What usually happens at convertible note maturity
Because founders sometimes worry about the worst case, one school of thought is that notes should automatically convert into equity at maturity. Under that approach, the note includes a maturity date automatic conversion provision, or conversion at maturity occurs at the option of investors.
In practice, an automatic conversion at maturity is usually a mistake because it tends to be investor favorable, not company favorable. If you are a startup, you should be cautious about agreeing to a maturity date conversion provision for the reasons below.
Extra negotiation and the punitive pre-money valuation at convertible note maturity
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 maturity?
Most investors do not want to receive common stock through a maturity conversion. So if you agree to a maturity conversion provision, you may have to define a form of preferred stock for the notes to convert into. Sometimes this can be expressed by referencing a standard seed round document set (such as seriesseed.com). Other times, you end up negotiating note terms and a preferred equity round framework at the same time, which defeats much of the speed advantage of a note.
(2) At what pre-money valuation should the notes convert at maturity?
Some investors take the view that if a startup has not completed an equity financing before the maturity date, it must be a sign the company is not doing well. Under that logic, they push for a conversion at a punitively low pre-money valuation, often much lower than the price cap that would otherwise apply at the next equity round.
This view is often wrong. A startup may not need additional financing before maturity, or it may be waiting to hit development or sales milestones to support a higher pre-money valuation in a priced round. Reaching a maturity date is not, by itself, proof of “failure.” But it can still become leverage for investors seeking a lower conversion valuation than the price cap.
Side note: incentive misalignment can flip the wrong way
Interestingly, convertible note alignment issues can come full circle. Originally, the price cap was introduced because note investors had less incentive (at least in theory) to help a portfolio company raise a priced round. If their help increased the pre-money valuation, the notes would convert into a smaller percentage of the company, even after applying a discount.
With an automatic maturity conversion at a lower valuation than the price cap, the incentive can flip. Investors may have less reason to push for a priced round if waiting for maturity yields a higher percentage of the company.
Relatedly, if the maturity conversion valuation is close to the price cap, and you are effectively negotiating conversion into something like Series Seed preferred stock at maturity, you should ask a practical question: why not just do a Series Seed equity round at that valuation and skip the convertible note?
Increased transaction costs upon conversion
An automatic convertible note maturity conversion can also increase transaction costs. If the notes convert into preferred stock (whether Series Seed or another series), the company often ends up paying for both a note financing process and, later, a preferred stock financing process. In many cases, the combined legal and administrative cost is higher than if the company had simply done a preferred equity round from the beginning.
Practical alternatives to automatic conversion
Extend the maturity date: the most common solution, typically approved by a majority of noteholders (in terms of investment $).
Convert in a priced round: keep the original bargain, meaning conversion at the discount and price cap when the next equity round closes.
Negotiate a clean up: in some cases, repurchase a portion, exchange into a new instrument, or otherwise simplify, but only with careful tax and securities analysis.
Conclusion
Automatic conversion at the maturity date of a convertible note is usually a bad idea and is often not in the best interests of the company. Fortunately, there are alternatives. The simplest solution is often an extension of the maturity date. While an extension requires investor consent (or at least majority consent), many investors will agree because they still want the notes to convert in a priced round. Of course, there are occasional situations where investors act irrationally and threaten foreclosure, but that usually reflects a mismatch in expectations and investor selection, not a problem inherent in the note structure.
Ryan RobertsStartup Lawyer
Ryan Roberts is a startup lawyer at Roberts Zimmerman PLLC with more than two decades of experience advising startups and venture capital investors. He is the author of “Acceleration” and StartupLawyer.com.
