The Pros and Cons of Convertible Notes

October 26, 2022

When growing SaaS companies decide to seek outside capital, they often do so by issuing convertible notes. As we explain in our primer, convertible notes are debt securities. But they can be converted into equity at an agreed-upon price in certain situations, making them a hybrid option for both the lender and the issuer.

Whether debt or equity, there are advantages and disadvantages to each potential capital-raising method. With this in mind, let’s look at the pros and cons for founders of issuing convertible notes.

Pro #1: Raise Money While Keeping Control

Early-stage companies need capital to grow, but their founders are understandably keen not to lose control. That’s why a convertible note can make a lot of sense: It allows the earliest shareholders to raise money without diluting themselves overnight into a position of minority ownership or loss of outright control over their company. If the company’s value rises over time, diluting later is better than diluting now. In addition, it may be possible for the company to repay the loan before the conversion occurs, which means not only will the business get much-needed cash, but the founders may not have to suffer any dilution as a result.

Pro #2: Payment Structures Can Aid Cash Flow

Cash is king for any business, and this is especially true for those that are just past the bootstrap stage. Any founder or CFO thinking of taking on debt needs to be mindful of repayment obligations and how they might impact the company’s liquidity position. There is good news with convertible notes? They can be structured so that interest is accrued until maturity rather than paid out incrementally. This approach may prevent a cash crunch and give the start-up the breathing room to use the funds it’s borrowed to turbo-charge growth.

Con #1: Convertible Notes Are Debt, After All

There’s no such thing as a free lunch when it comes to debt. In the case of convertible notes, the company issuing them is responsible for making interest payments—and principal repayment as well. Convertible notes tend to come with interest rates between 8-12%, and if they are accrued over a number of years, this can represent a significant liability on a company’s balance sheet. Outside of the interest rate, the conversion to equity is where the debt holder sees upside if the company performs well, and the debt holder gets to convert into equity at a pre-agreed price or at a set discount on the price any new equity gets raised at.

Con #2: Founders Aren’t First in Line Anymore—or They May Get Diluted

The ideal scenario is that the start-up borrows the money using a convertible note and then proceeds to grow rapidly. But sometimes, life doesn’t go as planned. If revenues shrink, the comapny may be in default depending on loan covenants, sometimes the noteholders may get to take over control of the company, as they sit higher in the capital structure than equity holders.

On a good case that the company does raise an equity round and the debt holders converts to equity, what the shareholder has done by taking the initial convertible debt is kick the equity valuation question down the road to this point where new equity is raised, the existing shareholders still get diluted. Convertible note holders typically have the right to a 20% discount (of the priced round) when it comes to conversion, which means the founding team will see their share whittled away even more.

Know What You’re Signing Up For

The devil is in the details. If you’re a founder thinking of raising money via a convertible note, make sure you fully understand and appreciate the specific terms and conditions of the deal. There are many convertible notes, each with varying payment structures and trigger events. The last thing you want to do is take the money now and wish you hadn’t tomorrow. This debt can be the right choice if used to grow your company and doesn’t result in too much dilution down the line.

If you are exploring funding options, we’d love the opportunity to chat. Schedule a time to talk to us and see if debt is the right solution for your business.