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A convertible note learning lesson

Venture south fallback
Venture South Team
Last updated: June 3, 2024
Venture south fallback

From our earlier blog post on convertible notes, you can probably tell that we are not big fans of them, though we concede that as a “bridge” to an imminent “event” (like a new round of financing, or an exit) they are a useful financing tool. (AVC agrees.) VentureSouth members have made several angel investments in this kind of bridge note, including several lucrative “bridges to exit” – one being our investment with our best IRR, over 2800%. 

Recently, though, we learned a tough lesson about converting convertible notes that we might be instructive to share. It's a complicated one, but we think worth the effort to understand.

Compare these two different “change of control” terms:

  • In the event of a Change of Control…the outstanding principal [and interest]… of this Note…plus a premium equal to 10% of the outstanding principal amount of this Note, shall be due and payable upon the closing of such Change of Control.
  • In the event [of]…a Change of Control…then the Balance shall, immediately prior to or contemporaneous with the Change of Control, automatically convert into the number of shares of Common Stock at the time of conversion equal to the quotient obtained by dividing the Balance on the conversion date by…ninety percent (90%) of the price per each Outstanding Equity Security at which each Outstanding Equity Security is valued for purposes of the Change of Control transaction….

Modeling these terms, you would get to the same result in either method – a roughly 10% gain for the lender. Most of the time – but not all. Why? 

In the first scenario, the noteholder never becomes an equity holder. They remain at the top of the “waterfall,” and get their $1 and 10c return without worrying about what happens further down the waterfall

In the second, the noteholder turns into an equity holder, and so loses its place at the top of the waterfall. The “bad stuff” that can happen down a waterfall can therefore happen to them too, which can impact that return. 

What is the bad stuff? Firstly, the costs associated with the transaction. Let’s say the headline price of the share purchase was $1 per share. Therefore the noteholders convert at a 10% discount, so 90c / share, and would expect to receive the $1 per share in proceeds. Right? Unfortunately, not quite. Transaction fees – like paying investment bankers, attorneys, “banking agents” (our new least-favorite type of transaction expense), and wire fees – plus a near-unending list of other adjustments mean the actual proceeds would be less than the expected $1. 

Those fees, generally, are irritating (and permanent) but small. But often a transaction includes an “escrow”, where a portion of the proceeds are set aside in an account monitored by an independent third party. If something the seller said turns out to be untrue, those funds can be claimed by the buyer. The bad news here? The converting noteholder’s returns can get caught in that escrow. They might therefore not receive the expected $1 in full for some time. This escrow impact is especially upsetting in this scenario because of math. The 10% of the proceeds put into escrow is larger than the 10% gain we were expecting – so we didn’t even get 100% of our investment back at the closing here! 

With some figures, let’s say: 

  • I invested $1
  • My 10% gain means 10c of gain and total gross proceeds of $1.10
  • 10% of the proceeds going into escrow is 10% of $1.10 = 11c into escrow
  • My net return at closing is therefore $1.10-11c = 99c 
  • Gain so far = MINUS 1c ☹

We would expect to get those 11c when the escrow period is over – but that could be months later, which isn’t quite such a great rate of return… 

Were we foolish to invest on a note with the second mechanism? Managing to lose money (so far) on an investment specifically designed to bridge to the exit that actually occurred suggests that…yes. 

On the other hand, there were process reasons to do it. A silver lining, though, is that in the first scenario the “upside” is limited to 10%. By converting to equity, you share in upside potential. Perhaps enough unexpected “good things” happen before the final payouts are complete – like good operational performance after exit triggering a substantial earnout payment – to make the short-term pain worth the long-term gain? Fingers crossed. Still, the biggest lesson here? Even when you (usually) know what you’re doing, angel investing is hard. This is not a mistake we will make again, and hopefully now you won’t either.