How to Avoid Risks Associated with a Convertible Note

convertible note risks

We’ve already covered the basics of a convertible note. In general, it’s a tool that can help you raise funding when your startup is at a very early stage.

Sounds great, right? Unfortunately, convertible notes can create trouble for your business further down the road. For example, a noteholder that comes to your rescue in desperate times may end up with a larger portion of your company than you expected. Or, you could take on too many obligations and put your reputation on the line if you fail to fulfill them.

In this piece, we’ll be spotlighting potential snags in the terms of convertible notes. Dive in and learn what you should keep in mind right from the start. 

Risk One: Accepting Unfavorable Conversion Terms

The person that holds your convertible note— the “noteholder”—is rarely the only investor in the game. You might attract a bigger investor from a Series A round as your startup grows. Typically, it’s at this point that the convertible note turns into equity.

As everyone knows, the devil is in the details. In this case, those tricky details are all about when you pay, who you pay, and how you pay (with stock or money). Let’s take a look at two scenarios and see how things could play out.

Scenario A: You issue shares to the Series A investor before the noteholder (your very first investor).

After raising the Series A funding, you issue shares to the investor. The total number of shares increases while your ownership stake decreases. The Series A investor gets their fixed percentage of ownership. It’s specified in the investment deal and locked in, so their ownership remains unchanged until the next priced round.

Next, you deal with your debt to the noteholder. Again, you issue shares, increasing their total number and reducing your ownership stake. The Series A investor isn’t affected because their percentage is fixed. So, it’s only your ownership stake that takes a hit and decreases.

In this scenario, you repay both the investor and the noteholder. The outcome is that your ownership stake is reduced twice.

Scenario B: You issue shares to the noteholder before the Series A investor puts funds into your company.

The Series A investor offers you funding, but you get them to agree that you will settle your debt with the noteholder first. So, you issue shares to the noteholder before the Series A investor gives you money. The total number of shares increases, while your ownership stake decreases. Now the noteholder gets their shares. Unlike the Series A investor’s fixed percentage in Scenario A, the noteholder’s stake isn’t locked in—convertible notes don’t have a fixed number of shares.

Next, you issue shares to the Series A investor. Once again, this increases the total number of shares issued. Meanwhile, the ownership percentage of the existing shareholders (you and the noteholder) decreases. The difference is that this time, both you and the noteholder are affected. The noteholder’s percentage is cut along with yours, meaning you share the impact of dilution.

In this scenario, your ownership stake isn’t reduced as much as it would be in scenario A. That’s because the noteholder’s ownership also gets smaller, and you’re not taking the hit alone.

Timing matters. It’s better to deal with fixed obligations last to ease the hit on your ownership.

Risk Two: Giving Away Shares Too Cheaply With a Low Valuation Cap

Another risk arises when determining the valuation cap. This is tricky at the early stage because there’s no data on your startup’s performance. All you can do is speculate on its worth. Of course, there’s a chance you’ll be too cautious and set it too low. Or, you might be overly optimistic and set the valuation cap too high.

Both scenarios carry risks—let’s explore how they might unfold.

Scenario A: You put a $5 million cap in the convertible note, but you later discover you were unfairly pessimistic about your own product. Investors now value it at $50 million! The trouble is that the noteholder will convert their note into shares as if the startup only raised $5 million. That means they get their shares at a price 10 times cheaper than other investors. A great day for the noteholder but a bad day for you because you give away more ownership for too little money.

Scenario B: Let’s now consider a scenario where you have overvalued your business. Imagine you set a $50 million valuation cap. The noteholder perceives this high valuation cap as an indication of your future success and agrees to give you money. No immediate drawbacks, right?

Next, you’re heading into your first pricing round. Investors think your worth is closer to $10 million. Now, the convertible note converts at this lower valuation, not the $50 million cap you set. This isn’t a problem—technically speaking.

But here’s the catch. Do you remember the old saying, “Never negotiate too good of a deal, because then you will have to live with it”? Well, this is where it bites. Investors might start to doubt your judgment when they see your over-ambitious valuation. And the noteholder? They’re none too pleased, either. Your reputation takes a hit, and raising funds in the future might just get a whole lot more challenging.

It’s critical to set your valuation cap carefully. Don’t go too high or too low. Base your decision on research, analysis, and realistic projections.

Risk Three: Deterring Investors With Too Much Debt

Many startup founders overlook the fact that a convertible note is a debt. Issuing too many notes can be a red flag for future investors, as it may suggest your company has taken on too much debt.

Here’s a rule for early-stage founders: for each $1 you raise in debt during the pre-seed round, you need to raise at least $5 in Series A. This way, you’ll manage to pay off your debt and have the money to develop your product.

Let’s look at this risk in more detail with these two scenarios.

Scenario A: You’ve raised $1 million via convertible notes. Now, you’re aiming to raise your Seed A investment. Adhering to the formula we’ve mentioned, you need to raise $5 million to look trustworthy. Is that feasible? Absolutely.

Scenario B: In this case, your convertible notes are worth $3 million. For an investor, this means you have a lot of obligations to others—whether they are issuing shares or making repayments. To balance your obligations, you’ll need to raise at least $15 million. For the first priced round, that may be pretty challenging.

Typically, investors are comfortable when 10–15% of their investment goes toward paying off this debt. 20% is also acceptable, although some investors may frown upon it. Giving away more than 20% of the company’s ownership in convertible notes doesn’t look good. Investors might doubt your ability to manage financial resources effectively. So, before you raise funds via convertible notes, be realistic about what you could raise in Series A.

Bottom Line

When you deal with a convertible note, you need to really dig into the terms. Yes, the noteholder expects special, more beneficial conditions—that’s because they are taking on more risk than later investors—but you shouldn’t overlook your own interests. Some terms in the convertible note deal may hit you harder than expected. And never forget that your trustworthiness is your capital, so take good care of it.

Forewarned is forearmed. At the Softeq Venture Studio, we explain different strategies to our participants so that they can avoid pitfalls like this. By the end of the program, you will be well-prepared to negotiate better clauses.