AA 010: Convertible note explained. Can you lose the whole company?

TL;DR: Convertible note explained- understand you won’t lose the whole company if you grow really fast

Welcome to the tenth podcast of the Ask Alex show! Today the question is “If a startup that raised seed money via a convertible note grows quickly, can they lose the whole company?”

In this podcast, we explain

• The difference between convertible notes and priced rounds
• The key terms of convertible notes
• That convertible notes don’t imply control

Listen to learn more!

Show notes on convertible note explained

Understand convertible notes and free tools!

• Convertible note conversion math at Series-A. You don’t know how it really works!
• Key convertible note terms that no one understands and cost you big
• Seed round convertible, priced and SAFEs. What venture capital terms are standard?

Cap tables

• Ultimate startup cap table and return analysis template
• Pro cap table and return analysis

 

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Transcript if you prefer to read

Hey, 50 Folders! And welcome to the Episode 10 of the Ask Alex podcast. Today we’ve got a question from Tim in the Bay area who asks “If a start-up that raise seed money via convertible notes grow quickly can they lose the whole company?” Well, thanks so much for asking that Tim. Let me try and break this down for everyone to understand a little bit better. So, you’ve raised your money you’ve got typically two options to raise money one is for a convertible note or one is what’s known as a priced round.

What’s the difference? Well, convertible note is debt, they don’t actually own any shares of your company but also the benefit of that is in the event of a liquidation debt ranks higher than equity on the capital so they’ll get paid out first so it’s actually a beneficial security to them. Where is if you do priced round the investors automatically own a stake of the company and they actually know how much they own so as a convertible note investors actually have no say over company at all. They don’t really have any control rights they will possibly get some depending on the terms when they actually convert into equity.

So convertible note is an option to convert into shares of a company at a predefined time. Now what is that? It’s typically at what’s called the qualified financing round. So, if you’re raising your seed a convertible note that qualified financing round will be your Series A assuming with great luck and a lot of work you actually get there.

So let’s talk briefly about the main terms in a convertible note, you won’t necessarily always have these terms if you’re really good at negotiating, you may not be able to get them but let me just run through them. So you’ll have a discount, discount says you will get a 20% discount to whatever the share price is at your Series A so if you’re investing at a formal valuation and you have a 20% discount then your investors are effectively investing at a valuation of 3.2.

Next you have this thing called a Cap. A cap effectively sets a cap on the price which they may be able to but buy their shares at. Typically you’ll have both if you’re really hot you may not have a cap which is called uncapped note. But most cases you’re going to have one of those and then investors will be able to choose whether or not they take the discount or they use the cap in terms of calculating the share price.

So the tricky thing about convertible notes is investors don’t actually know how much they own until that qualified financing grant actually happens. I know a super duper famous former CEO of one of the largest companies in the world who’s going to invest to my buddies startup angel round and he said “I do priced round because I want to know how much I own, I’m not interested in doing convertible notes.”

So you’ll actually find that there are investors who will not even do convertible notes. Because they don’t know how much they own. Now, if your round is pretty small maybe they not necessarily care but if you’re raising say one and a half million on a convertible note you can be darn sure that there will be certain investors who think that’s just too much risk and uncertainty and these days really convertible notes aren’t that much cheaper and not necessary that much faster than doing a priced round. There’s a lot of Series C documents particularly in countries in the US where it can be pretty easy to get your Series C documents done or your priced rounds.

Anyway, let me get back to your real question here. Since you’re raising on a convertible note investors don’t actually have any ownership of your company. Their influences relatively limited, so they can’t.. you can’t lose your company. When you have done a priced round or actually converted to shares if there are certain terms in there such as the ability to replace the CEO which will require certain voting rights then there is a possibility that they can remove you as the CEO and therefore your ownership of the company will depend on your vesting agreements with them and typically investors will always make sure that you have vesting terms so if you’ve been working on the business for a while they may allow you to have some vesting up front so if they want to have 4 year vesting they’ll say “Well, in lieu of the work you’ve done you will vest 25% of shares already and you have to vest the additional 3 years to get the other 75%.”

So if somehow they were to remove you, you’ll end up owning 25% of the shares that you had as opposed to the 100%. But investors are investing in you; they are investing in the team. It is very rare circumstances that investors really want to remove you from your company because you are effectively the company.

So that’s not something I’ll be terribly stressed about. If you deal with less reputable slightly dodgy people there are certainly stories where user founder try and save a whole bunch of money on legal fees didn’t really understand what was going on and your investors do and they purposely invested with the sole objective to take control of your company for you and run it themselves.

I’ve heard this happened 3-4 times it’s fairly rare. Investors run this game for the long-term at least the good ones so it’s not something you should be terribly worried about but certainly with convertible notes there’s just no way that investors can have the control to actually wrestle control for the company from you. There’s no way you can lose your whole company for it you know indeed if your company is going fast you get a lot of options.

Investors are going to want to invest in you and if you do have sketchy seed stage investors who invested convertible note, investors may actually only invest on the condition that you remove those investors, so all you have to really worry about is your lead investor at the Series A who has lead investor rights.

Now I tried to give you some explanation about how convertible notes and priced rounds work if you’d love to know a lot more and be a boss on this topic. I got a ton of awesome blogs and free Excel tools which will help you do the math and really understand what’s actually going to happen here. I’m going to put those in the show notes for you and you can download them for free.

If you’re wondering what’s actually going to happen on a convertible note then I have some free tools there and that will actually calculate for you what the potential ownership stake of convertible note holders at your seed round will be and you can put in a range of values to kind of see what that will be if you raise let’s say 4 million or 10 million valuation assuming you have discounts or caps.

If you want to take this a little bit more seriously you need to have a cap table. Hopefully I’ll get to talk about this in a lot more detail. I have two cap tables for you, one is called the ultimate startup cap table and returns analysis template and you can get that in my blog and if you are a little bit more of a pro I have a pro version cap table which does a whole lot more for you and a whole lot more calculations. It took me months to do but it’s pretty awesome. Check out what makes sense for you and if I can help with any work feel free to reach out to me.

Okay, guys! If you would love to be featured and have your question answered on Ask Alex feel free to reach out to me at alexanderjarvis.com/AskAlex and you can ask your question there. Thank you so so much for spending time with me guys. I really really appreciate you.