The Pros and Cons of Convertible Notes, and are ‘Safe’ Notes really safe?
Convertible Notes are reasonably well known in Australia; whilst ‘Safes’ are far more prevalent in the USA but are slowly working their way into the Australian corporate vernacular.
Unlike priced equity, they offer flexible features that, at least on first blush, can be very compelling. But there can be a sting in the tail, or should we say “trail”?
It’s really only at the back-end of your deal, when the relevant valuation is no longer a theoretical, futuristic concept, that the true effect of dilution (or the true return on investment), will be known.
Sooner or later the pricing game will catch up with you. The legacy it leaves all depends on how savvy you were when choosing the instrument and building its features, and of course your bargaining power at the time of seeking investment.
This article explores some basics to get you started.
Convertible Note Features
|Advantages||The key advantage is flexibility:
• Valuing an early stage business is difficult and expensive. Valuations can be delayed until more data is available.
• Money up front – dilution later (but amount uncertain).
|Disadvantages (for the issuer)||• Terms can become complex.
• Accounting can become complex.
• It’s a debt – so insolvency may be a real threat.
• Various features can result in uncertainty, can be highly dilutive to Founders, and may restrain future valuation potential.
|Other common key features||Can be:
• Secured or unsecured;
• Subordinated (to other unsecured creditors);
• Redeemable (i.e. can or must be redeemed prior to maturity at option of a party, or upon certain circumstances).
|Maturity||The date when a note must be repaid (in cash) or converted (if no conversion trigger event has occurred). The former creates a higher risk for insolvency. The latter requires the valuation at Maturity to be linked to an agreed mechanism (e.g. EBIT multiples).
|Coupon Rate||Issuers should avoid if possible.
A coupon rate is the rate of interest payable on the funds advanced prior to conversion. It may be payable in cash, or capitalised (further diluting the Founders).
|Discount on equity conversion||Issuers reduce if possible.
Discounts are used to compensate the investor for the additional risk of accepting a hybrid investment. They deliver more equity to the investor – meaning greater dilution to the Founder.
|Valuation Cap||A cap will restrain the valuation achievable at the next monetisation event.
A maximum pre-money valuation at which the convertible loan may convert into equity is sometimes imposed by investors.
Theoretically the cap should increase with brand awareness and revenue predictability.
|Conversions||Who gets to choose?
Typically on either the discount rate or the valuation cap – often whichever gives the investor the higher price.
|Founder dilution||Caps (particularly ones that are too low) and high discounts on conversion will have a greater impact on Founder dilution.
Even from an investor’s point of view, this may not be a good thing. A Founder with more skin in the game is more likely to be highly motivated – and sometimes, the Founder is the business.
|Accounting Issues*||Accounting treatment changes and can be complex depending on note terms. Remember, it is a hybrid instrument. From Day 1 it (or a component of it) will be classed as debt.
But simply accounting for it as debt until conversion may not be the whole picture. There may be an initial equity component, depending on where the optionality (or contingency) sits.
|Australian Taxation Issues*||Generally gains are not taxable on conversion, but upon later disposal of the resulting equity (as a capital gain).
Notes with coupon rates will also carry an income component, subject to income tax in the period received.
|Corporation Act Treatment||Many convertible notes will be debentures (basically a right to sue on an undertaking by the issuer to repay funds advanced as a debt), which also fall within the definition of securities.
Because they are securities…
At a minimum, offers of Convertible Notes are subject to the same disclosure requirements as offers of shares. A prospectus is required, unless a disclosure exception(s) apply.
Because they are debentures…
They are also subject to the Debentures Chapter of the Corporations Act.
Where no (fundraising) disclosure exceptions are available, in addition to a prospectus, a Trustee and Trust Deed are also required, with additional statutory duties of the Trustee and the issuer/borrower (including quarterly reporting). Notes that are secured may attract additional disclosure obligations.
Statutory naming conventions also prevent Convertible Notes from using the descriptor “secured” unless minimum requirements in relation to the type and adequacy of security are met.
|ASX Treatment (ASX GN34)||ASX classifications do not necessarily accord with ordinary parlance.
ASX guidance governs when a security should be described as “debt security”, “convertible debt security”, “equity security”, “hybrid security” or “wholesale security”.
This matters, because different rules apply to different types of securities (such as the 15% rule for equity securities).
Most common forms of Convertible Note will be either a “convertible debt security” or “equity security” for ASX Listing Rule purposes.
“Equity security” includes a “convertible security” – being one that is convertible/exercisable at the option of the holder, or by the terms of the note.
But note, a distinction is made from “converting” or “transformable” securities.
* Accounting and tax sections are high level and simplified.
‘Safe’ Notes – What are they, and what makes them ‘safe’?
‘SAFE’ = Simple Agreement for Future Equity. Unlike a Convertible Note, there is no debt component. It is just equity that hasn’t converted yet.
The term ‘Safe Note’ is somewhat ill-fitting, as the term ‘Note’ is most common to debt or hybrid instruments with debt like features. The acronym ‘Safe’ may also be considered by regulators (and ordinary people) to be misleading, and should not lull issuers (or holders) into a false sense of security.
Because it is not debt, concepts such as Maturity, Security and Coupon Rates are not relevant. However, Discounts and Caps are, and should be carefully considered (and modelled) before you dive in.
So why agree to deferred equity if there’s no yield on the way through? One article has referred to it as “kicking the valuation can down the road”. Let’s take a closer look.
|Valuation Cap||It sets the floor for the next equity round.||It may act more like an anchor and hold back value realisation.|
|Deferring the valuation and the conversion||Postpone equity pricing until valuation is higher.||Sooner or later the equity will be priced, and past and current dilution will come home to roost, all at one time – delivering a compound effect on Founder dilution.
By deferring the pricing, everyone is taking a gamble.
|Dilutionary impact||Dilution is deferred.||It isn’t really – you just didn’t know the dilutionary impact at the time of issue. Big falls in Founder’s equity can’t be blamed solely on the new financing structure or price – after all you already issued the SAFE!|
|Easy to use and duplicate for multiple funding rounds||Low cost and simplicity makes multiple raisings with different valuation caps more accessible.||The cascading effect of conversions may be enough to turn off future investors.
Keep a close eye on investor numbers and don’t lose sight of disclosure requirements.
If there is one piece of advice anyone considering using a Convertible Note or SAFE should consider, it is this: be realistic about pre-money and post-money valuations and prepare various modelling scenarios for your capital structure to understand the dilutionary impact / return, before heading into negotiations.
Do the hard work now or be stung later!
This article was written by Olivia Christensen, Special Counsel – Commercial