Tuesday, June 02, 2015

some important thinking on convertible notes and liquidation overhangs

Two blog posts on convertible notes popped up recently and I thought I'd detail them a bit more in my own language. But you might be better served to just jump over to Brad Feld's post "The Pre-money vs. Post-money Confusion With Convertible Notes" and Mark Suster's post, as well as a further post, The Problem in Everyone’s Capped Convertible Notes by José Ancer.

The issue being discussed is a problem that has resulted from the use of convertible notes as investment rounds in and of themselves instead of as bridge notes to the next financing round, which is how they were originally intended. If a convertible note is used as a bridge, there is relatively little increase in value between the notes and the next round. But if a convertible note or notes stay in play for a longer period of time--say 12-18 months--then in the ideal case scenario, the value of the company has grown significantly. The problem is a feature in most convertible notes where the holders get an increased liquidation muliplie upon conversion if the valuation cap on the notes is exceeded.

Here's how it works.

Let's assume...
  • you're an entrepreneur who has issued $500k in convertible notes to investors
  • the convertible notes carry a $2.5MM valuation cap
  • new money invests $1MM in a Series A at $1 per share
  • the Series A is participating preferred with a 1x liquidation preference
Scenario 1

In our first example, we'll say that the next round investors invest at a pre-money valuation equal to that $2.5MM cap. New money would get 1,000,000 shares in Series A stock ($1MM * $1 per share) and the convertible note holders, upon conversion, would get 500,000 shares in the same Series A ($500k at $1 per share, ignoring interest in this example). The post-money would be $4.0MM. The new money gets 1x participating liquidation preference. In other words, regardless of what the company sells for, everyone with Series A gets $1 per share back on top of their participation on a pari passu basis with Common Stock holders.

Here's what the cap table looks like:

Common Stock: 2,500,000 shares or 62.5%
Series A (new investors): 1,000,000 shares or 25%
Series A (former convertible debt holders): 500,000 shares or 12.5%

If the company sells for $4.0MM, Series A would get $1.5MM out, and then get their pro rata portion of the remaining $2.5MM (37.5% in this case). This sort of participating preferred is pretty standard--almost every single one of the deals we at Long River Ventures have ever done has this feature.

If the company sells for $10MM, new investors get $1MM, note holders who are now Series A get $500k, and then both share in the remaining $8.5MM with Common.

If the company sells for $20MM, the Series A would get out their $1.5MM and then their pro rata portion of the remaining $18.5MM.

With me so far?

Scenario 2

Now let's assume that the $2.5MM cap comes into effect because next round investors think the company has done really well and are willing to invest above the cap set in the convertible notes. Let's assume that next round investors invest not at the $2.5MM cap but at a $10MM pre-money valuation. Let's assume they still invest $1M in a Series A and still get shares at $1 per share. They would get the same 1,000,000 shares as in the above example, but much less of the company. The convertible note holders wouldn't get 500,000 shares, they'd get 2,000,000 shares--remember, they have a $2.5MM cap and the valuation was $10MM. Therefore, they get 4x the shares in the first example. As an entrepreneur, you may not like that but that's what you signed up for.

Here's what the cap table looks like:

Common Stock: 10,000,000 shares or ~77%
Series A (new investors): 1,000,000 shares or ~8%
Series A (former convertible debt holders): 2,000,000 shares or ~15%

What you don't realize you signed up for is the same thing on the liquidation preferences.

Let's also assume the 1x participating preferred liquidation preference also holds in the second example. Just like in the first example, new money would get $1MM upon liquidation regardless of the company selling price, and then get their pro rata portion. However, the convertible debt holders would get a 4x liquidation because these liquidation rights are written on a per share basis, not on the amount of money invested. In other words, they are guaranteed to pull out $2MM off the top on their original investment of $500k.

If the company sells for $4.0MM, new investors get their $1.0MM back, note holders who are now Series A get $2.0MM back, and then all share in the remaining $1MM (pro rata of Series A in this second example is 23%).

If the company sells for $10MM, new investors get $1MM, note holders who are now Series A get $2MM, and then both share in the remaining $7MM.

If the company sells for $20MM, new investors get $1MM, note holders who are now Series A get $2MM, and then both share in the remaining $17MM.

Compare this second $20MM example with the same example above. The difference between $18.5MM and $17.0MM after payment of preferences is where the liquidation overhang lies.

To keep the illustration simple, I didn't include the discount on the next round that convertible note holders are also likely to get. In most cases, there would be a discount on the next round as well as the valuation cap so they would do a little better than this example. If you think that convertible debt holders get enough recognition for their risk in that discount and with the valuation cap, and that the liquidation overhang is overreach, go to the above blog posts for some solutions to this problem.
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