Investing in Start-Ups: An Introduction to Convertible Notes

By Alan W. Wong

For a number of years, start-ups have often structured their “friends and family” or angel financing rounds as convertible notes, which are loans that may be converted into equity. While investors in early-stage companies usually prefer to purchase preferred equity interests, founders often insist on using a convertible note structure, so investors who are interested in investing in early-stage companies need to understand convertible note issuances.

Start-ups favor convertible notes over direct equity investments because the issuance of convertible notes tends to be quicker and cheaper for several reasons, including the following:

  • An issuance of convertible notes permits a start-up to raise funds without having to determine a company valuation. An equity investment requires the start-up and the investor to negotiate the value of the equity interests that the investor will purchase. This can be very difficult and speculative in the context of an early-stage company when the company often has no revenue or is operating at a loss.
  • The legal documentation for a convertible note tends to be simpler than for an equity issuance. A convertible note issuance commonly only requires the drafting of a convertible note and a purchase agreement. In contrast, a typical equity issuance would require the start-up to amend its organizational documents and negotiate a shareholders agreement and other ancillary documents. The legal documentation for an equity issuance in an early-stage company can be particularly complex because equity investors typically demand preferred equity (instead of common equity), so the rights of the preferred equityholders are an additional point of negotiation.

Numerous websites provide forms of legal documents for convertible note issuances, and founders often try to use those forms without any legal review in order to avoid legal expenses. Obviously, the forms available online or otherwise presented by the company are almost certainly not aimed toward protecting the interests of an investor, so investors should be sure that their legal advisors review the documents.

From an investor’s perspective, the simplicity of a convertible note issuance may help to reduce the transaction costs associated with the investor’s investment. Furthermore, if the company goes through financial distress, the investor, as a debtholder, would have the advantage of having priority over other equityholders. Despite these benefits to an investor, a prospective investor is well served to find experienced legal counsel to provide guidance on the various intricacies of convertible notes, including the negotiation of key terms of the documents, such as the note conversion formula, which is usually quite complex, and the analysis of the tax implications of the investment.

For more information on investments in early-stage companies or other business and finance matters, contact Alan Wong at [email protected] or 215.496.7253.