Convertible notes can add flexibility for many angels, as I wrote last week. I really like how Angela Jackson thinks about these deal terms for first investments in startups, but it also got me wondering: are angels still debating notes and priced rounds? I did a quick poll of angels, and boy did I get an earful. It’s safe to say the debate is on! Last week more than 100 members of the Angel Capital Association (ACA) responded to the survey. While not a scientific sample, it provides solid market representation since respondents were angels from across the US and Canada and invest in similar sectors and stages as the full ACA membership. Here’s what I found out:
- 82% prefer to do priced rounds for their initial investments BUT
- 78% had done at least one convertible note in the last 18 months AND
- 25% used convertible notes for more than half of their first investment deals
Interestingly the preference for convertible notes has actually doubled since 2011, the last time I surveyed about deal term preferences. Clearly angels are drawn to certain convertible debt deals or companies, even if they don’t love the deal terms. This feels like evolutionary change to me. Another thing that surprised me: while I thought geographical location would correspond with preferences – e.g. Californians would most like convertible notes – this wasn’t supported by the survey results. Midwesterners were just as likely to prefer convertible debt, for instance. A few respondents didn’t see convertible notes versus priced rounds as an either/ or decision. These angels viewed deal terms as a matter of what the deal looked like or how many investors were involved, and considered notes as “another tool” for investors. However, the larger majority strongly felt that it is an either/or choice. So why is that? Here are the main reasons:
- Missing investor-entrepreneur alignment – Many angels use the term sheet negotiation process to make sure they’re on the same page and to ensure that the final deal sets terms align entrepreneur-investor incentives. Said one respondent, “Unless the convertible has a low valuation cap, we are loaning CEOs money to achieve a valuation that we never would have agreed to in the first place. We are playing on opposite teams, where the CEO is using our money to achieve proof points to give us a crushing valuation (in the next round).”Another said that notes reduce the need for financial modeling and discipline, not only creating strange incentives, but setting the tone for disagreements to fester. Still others mentioned that they don’t get to be on the Board of Directors with notes, further disconnecting the early investors and company.
- Not wanting others to set the valuation - There are up-round risks for all angel investments and perhaps even more with convertible notes. As one respondent said, “The valuation of my investment is now determined by others, whom I may not know and who may have bad judgment, later.”
- Next round investors didn’t honor note terms - Beyond others setting valuation there is another risk with next stage investors: at least two of the angels in the survey had the unpleasant experience of investors behind them not honoring the terms of the note. Each commented that they would have ended up with better terms in the A round had they started out with a priced round. Part of the issue is that their notes did not include investor protections that are normally included in an equity term sheet.
- Missing out on tax benefits – The US tax code includes a couple of important tax benefits for early stage investors, including one that allows you to monetize your losses and another the minimizes taxes on gains in qualified small businesses. The catch is that the “clock” for starting these benefits is when the investment is equity. When you invest in a convertible note the likelihood of missing out on monetizing big losses increases. Additionally, you have to wait until the next priced round –plus five years – to qualify for a 50 percent exclusion on taxes from a successful gain. There are also some tax liabilities on interest from loans to be aware of when notes convert to equity.
- Bridge to nowhere – Many convertible notes never convert to equity, if the entrepreneur isn’t successful in securing a next round. This makes some angels say notes are “bridges to nowhere.” Of course, investors can invest in companies using priced rounds that also aren’t successful in securing a needed next round either. Some angels feel strongly that they will only invest in a convertible debt when it is a true “bridge loan” in which the next investors are known and their investment is in sight.
So where does this leave us? Clearly, the debate on early-stage investment terms continues. For some, priced rounds may be the right choice because of certainty in pricing, more investor protections, alignment, and tax treatments. Still others will prefer that convertible notes provide great flexibility, reduced legal costs, and simple terms for all. The right choice is yours to make and in my opinion, there is no one right answer. Pick what is right for you.
