Why Seed Investors Don’t Like Convertible Notes
cdixon.org
cdixon.org
The biggest practical problem with these notes from the bridge investor's side is what happens if the startup finds an exit path before a qualified funding round occurs. In the worst case, such investors effectively find themselves in a position where they get only their money back with a little interest - and all for having taken the largest funding risk of all (not quantitatively but qualitatively, since the early bridge money comes in at the point where the startup is at its most under-developed).
The problem is mitigated by putting in provisions for a so-called "merger premium" - that is, a 2x (or some other multiple) payout in the event of a liquidation that occurs before a qualified funding. This is not a perfect solution, but it helps. I have also seen the opposite problem here, where bridge investors demand a "merger premium" that becomes almost extortionist - this only works, of course, if the startup is utterly despairing for cash (which does happen from time to time).
That said, the utility of such notes is beyond question. The problem of a premature value put on a startup's stock based on an arms-length investment is huge. It messes up option grants to early-stage people. It enhances tax risks for the founders if a valuation is done too closely to the time of the founder grants. And it puts the company in a position where it needs to start doing 409A valuations at a time when money is particularly tight and they can least afford to part with the cash needed to do them. The convertible note eliminates all of these problems with a pretty elegant solution. That is why it has become a staple in the startup world.
Such a note can also be prepared at the cost of a few thousand dollars max in a typical case, which is another plus that gives it large appeal among founders looking for bridge solutions to their funding needs.
Tax gets complicated in these areas but the general principle is that, any time founders or others need to vest shares, the IRS regards the value of those shares as service income, i.e., taxable income. That is why trivial valuations are used up front even though founders may in fact believe the value of their stock to be significant even right out the gate. Once founders permit any form of "measurable event" to occur - that is, any event (usually involving a funding but also can involve paying people in stock measured by the value of services performed) that gives the IRS a way of putting an objective value on the stock at a time when its value would otherwise be nebulous - then that measure begins to define potential taxable income to those who receive the stock after that event occurs.
So, if a founder gets 1M shares at $.001, and has to vest shares over 4 years, any taxable service income attributable to that effort is negligible ($1K) (assuming an 83(b) election is timely filed - http://www.grellas.com/faq_business_startup_004.html). But, if the company takes in bridge funding in such a way that the common stock has to be repriced, say, up to $0.20/sh, any later recipient of 1M shares of such stock would be dealing with potential service income of $200K.
This issue can also arise if founders do a $.001/sh capitalization, and then do a funding that bumps up too close in time to their own capitalization. In some scenarios, the IRS can treat these as one event and attribute significantly more income to the founders than might appear from their own $.001/sh pricing.
As I said, the issues get complicated but that gives you an idea of the general principles.
A convertible bridge note avoids these tax issues by letting founders get funding without having to price the stock in any way - in essence, the terms of the note say it is a loan, repayable at x date, and forced to convert into preferred stock on the same terms (except for price discount) as those used in any qualified funding occurring within y period. In effect, re-pricing of the shares is deferred until the qualifying round. This lets the company defer the "measurable event" to the date of the qualifying preferred-stock round and lets them keep pricing nebulous (and hence "cheap") until then.
The tax issue is real, but only delayed by avoiding a valuation. I think more creative forms of equity compensation are a better solution.
Founders should think carefully before using this solution and, in most cases, unless a more substantial funding is truly anticipated not too far down the road, should probably not use it.
Part of this depends on how "friendly" the bridge investors are. You can afford to use bridge notes a bit more loosely if the investors are friends and family or angels with whom you have a strong relationship. These investors will likely team with you and adjust their deal to meet continuing needs if things don't go as expected. This likely will not be true of potentially-not-so-friendly angels with whom you have no special relationship.
Of course, creative forms of equity compensation can be excellent vehicles because they cut the cash needs of a company dramatically. There are obvious limits to this, though, as other cash needs will arise as well in most startups.