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The “Princess Di Problem” of Convertible Note Financings [1]

May 2016

Perhaps the most popular structure for early stage financings is a startup company’s issuance of convertible notes in exchange for its first significant capital infusion.

What a terrible idea.

Early stage companies routinely lack the projected cash flows or other resources to have a realistic shot at complying with the terms of their indebtedness -- particularly that part about repaying their debts at maturity. But for the fact that investors are (almost) always well aware of this situation, convertible note financings sound like the classic ponzi scheme, in which a company would issue additional notes at a later date and repay the prior notes with those proceeds (and so on until the scheme is discovered).

Fortunately, the convertible note structure expresses a specific bargain between entrepreneurs and angel investors. This principal idea driving this bargain is that entrepreneurs are unwilling to sell equity in their fledgling companies at the equity valuations that early investors are likely to require in order to make their investment at that time. The logic for such a position lies in an entrepreneur’s strong belief that the company will be worth many multiples of what it might be worth now, but for the simple passage of a short period of time, during which the company will accomplish all of its performance targets (whatever those targets may be). In other words, entrepreneurs are not willing to sell something at today’s price that they see clearly will be worth many times as much tomorrow or the next day.

It is a critical – if unspoken -- underpinning to this negotiation that neither party believes the other party’s assessment to be incorrect. Entrepreneurs are not debating that their company may only justify a low valuation today, only that since it will undoubtedly justify a much higher valuation in a short time, it would be irrational to sell equity based on the current pricing. This is, in a sense, a form of “reverse inside information,” where, instead of trying to buy a stock because the buyer “knows” something, the seller refuses to sell stock for a similar reason. Of equal importance, angel investors may well share the views of the entrepreneurs regarding the short-term potential for the value of the company to appreciate significantly. However, the investors may not share this view sufficiently to agree to the “projected” valuation at the current time.

The grand bargain that has evolved in the early stage financing market can thus be summarized as follows:

Angel investors are willing to forego requiring that entrepreneurs sell them equity at its current market price in exchange for receiving the right to purchase equity at a pre-determined discount to its future market price.

The convertible note structure may actually be one of the more useful innovations of the private capital markets. It is worth noting that this was not always the case. There are as many historical anecdotes about company X or founder Y who sold 10% of what became a multibillion dollar business for, say, $50,000 [2], as there are about early stage investors who have built sterling and enduring (even if never quite replicated) reputations for being exactly “that” investor.

Still, this grand bargain is based on a bit of a logical fallacy. The facts that Company X could be worth $25 million dollars one year from now but is only worth $3 million dollars today are not inconsistent. Both numbers could accurately reflect the fair market values of the same company at two different (even if not particularly remote) points in time. In point of fact, an angel investor could note that a big reason that Company X might be worth so much more in a year or less is its ability to raise the necessary capital today – at whatever price it can command – to execute on its business plan. If entrepreneurs took the same position with later stage investors that they did with angel investors (e.g., “we will not set a valuation for our Series B round, but will give you a discount on Series C”), private capital markets would sputter.

The convertible note structure affords both parties the benefit of its bargain. By issuing debt instead of equity securities, startups can raise capital yet defer establishing a valuation for the company until the business has become more mature. By incorporating the familiar conversion discount and cap mechanisms into the terms of convertible notes, angel investors can assure themselves of a meaningful discount to the equity valuation that they expect an institutional investor will pay at a later point. Of secondary but also significant importance to angel investors, the convertible note structure allows angel investors to invest directly alongside institutional investors while risking much more modest amounts of capital. Had these same investors waited until the institutional financing round, they may have found themselves either subject to much higher investment minimums or excluded altogether by the institutional investors. Of course, had these same investors waited to deploy their capital, the company may never have gotten to the point of being able to raise such an institutional financing round.

Here’s the problem.

Angel investor (AI) invests in convertible notes of Company X that convert automatically into Company X’s Series A financing round at the lower of a discount to the Series A price or a conversion cap that were both negotiated at the time of the original convertible note financing. So far, so good. One year later, Company X negotiates a Series A financing round with an institutional investor (VC). After reviewing Company X’s capital structure – including the convertible notes – VC makes the following proposal:

We will purchase Series A Preferred Stock at the price and valuation we agreed with Company X. However, at the closing of our financing, all of the convertible notes will convert into a newly created Series A-1 Preferred Stock. The Series A-1 Preferred Stock will be sold at the same price per share as our Series A, but it will be junior to the Series A. Oh, and the cap and discount contained in the convertible notes will have to be waived.

So much for the grand bargain!

What AI missed is that there was “a third party” in the original agreement with Company X, namely, the as then unidentified (but not unanticipated), future Series A investor. Company X is not in breach of the convertible note terms, as it is not requiring the terms proposed by the VC. VC is not a party to the convertible note agreements, and thus has no legal obligation to “honor” the deal that would apply upon conversion of the notes. As a legal matter, VC is essentially “asking” for the original parties to the convertible note financing to alter their arrangement by conditioning its agreement to invest on this accommodation.

What to do?

I have thought about this problem from a legal perspective, and I don’t love most of the likely answers. One argument is that VC’s proposal amounts to tortious interference with AI’s and Company X’s contractual arrangement. I have yet to find precedent supporting such a claim. A similar argument might be that VC and Company X “colluded” in crafting VC’s proposal to AI. In support of this claim, AI could point out that VC’s proposal economically benefits Company X (or at least its founders) -- through the avoided dilution from the application of the conversion discount or cap – but the benefit to the founders comes at no corresponding economic cost to VC. This could be a challenging case for AI. I am again unaware of any direct precedent, but would look for guidance by analogy at Delaware case law regarding “wash out” (sometimes called “cram down”) financing transactions. Such guidance, to the extent applicable, would be discouraging.

Still, courts could rule, as a matter of public policy, that the agreement reached between AI and Company X must be enforced in the context of a transaction with VC. Public policy concerns are legitimate justifications for the exercise of a court’s equitable powers. Precedent exists in other contexts. For example, many practitioners will recognize the view that California courts will not enforce covenants not to compete that may be contained in an employment context. While that is an example of a court holding a contractual provision unenforceable, AI would be asking for the opposite relief – the specific enforcement of a contractual provision. Although still an equitable remedy, [3] such would arguably be a more restrained exercise of a court’s equitable powers than invalidating an unambiguous contractual provision. Essentially, a court could rule that Company X cannot avoid its unambiguous contractual agreement because of “subsequent developments,” on the grounds that if such an excuse were allowable, the very enforceability of contracts would become uncertain. I don’t love the idea of leaving the issue to a court’s equitable powers. I don’t expect that judges would love the idea either.

A market response may ultimately be the better approach. While it would be difficult to hold particular companies or entrepreneurs accountable for a “Princess Di Problem,” over time, the angel investor community might migrate away from the convertible note structure in favor of purchasing equity securities from the outset (i.e., going back to where this market started). Their doing so would impose the attendant cost to entrepreneurs of establishing an equity valuation for the company at what they consider too early a stage. If entrepreneurs formed the view that the cost of dilution from the lower priced initial equity financing was greater than the benefit from avoiding the application of the discount or cap at the time of a Series A financing, they might align themselves with AI at the time of the Series A financing. This approach might work well if in point of fact, the VC needed (or believed that it needed) the Company’s tacit approval to make such a proposal to AI. Secondly, the angel investor and entrepreneurial communities might make collective note of which institutional investors were most likely to attempt such a maneuver, rewarding good actors and snubbing bad actors. In a competitive market, with more money chasing fewer good investments, a market response may well produce a more concerted, efficient result than a judicial (not to mention legislative) campaign.

[1] This problem is not unique to convertible note financings. It can arise in any situation where the introduction of a third party can inconsistently alter an existing contractual relationship.

[2] Without having verified this, one of the more popular such anecdotes that I have heard involves a young Bill Gates offering a 5% interest in an early Microsoft for $25,000.

[3] The remedy “at law’ would be money damages rather than the specific enforcement of the cap or discount.