Sometimes Angel investors consider using convertible notes rather than direct equity. Equity is strongly preferred because it aligns the interests of the investors with the interests of the founders, while debt structures tend to create divergence of interests.
Correctly, it is a redeemable convertible note, that is, a loan to the company that will attract interest and, upon maturity, can either be repaid, or converted into equity in the company. Most commonly, the intention is that the note will convert on advantageous terms for the lender as part of the next round of funding that will be done as a priced equity round.
What happens when the company fails to get the necessary traction to attract that next round?
Convertible notes can be effective and are often problematic. What follows was Steve Sack’s experience.
In 2009, the early years of Melbourne Angels, I saw a pitch from an entrepreneur who had developed a SaaS application for recurring and usage based billing targeted specifically at MVNOs (mobile virtual network operator) and other 3rd tier telecoms providers. Having tracked a Silicon Valley start-up in a similar market that had raised a series B round, I could see the opportunity for Emersion in its focus areas and other market segments.
The founder’s valuation was higher than we wanted, another capital round was expected within 12-18 months, and we wanted downside protection. So, along with another Melbourne Angels member and several other Angel investors we settled on structuring the investment as a 4 year convertible note. At the time, Melbourne Angels standard investment trust structures and transaction documents were nascent. (I think this was perhaps my 3rd invested deal that was sourced through Melbourne Angels.)
After a short time it became apparent that the business was not getting the kind of traction it needed. Several of the noteholders stepped in to try to direct the ship and various advisors were brought in for interim roles. All to little effect!
By the time the notes reached maturity, the company was trudging through the valley of the living dead. It needed capital, but couldn’t support a valuation that the shareholders or noteholders would accept. The noteholders agreed to extend the maturity date, provided the company started paying back the accrued interest on the notes, and capitalising and compounding the ongoing interest. This, of course, put more pressure on working capital and the company limped along, slowly growing revenue, relying on ATO ‘overdraft’ and taking advantage of the R&D tax concessions.
The noteholders’ patience wore thin but, as no one was prepared to step in and take over the company, we were not prepared to call for repayment (which would have been a lose-lose for all parties). Possible exit and partial exit opportunities, many sourced by the noteholders, came and went. Interest repayments ceased and the compounding continued to weigh on the balance sheet. The founder continued to scrape by and, eventually, in 2018 the business cracked $1m ARR (annual recurring revenue) and looked set to move to positive EBITDA in 2019.
Finally, a potential acquirer appeared. After many months, a notes-for-scrip deal (and 12 month escrow) was agreed with Novatti (ASX:NOV). The transaction was set to close at the end of March 2020. To add a final wrinkle, the share market plummeted and the company’s shares dropped to about half the agreed value. The noteholders reasoned that the share price was likely to recover in the escrow period and there was no other potential liquidity event on the horizon. So we pulled the trigger (along with the shareholders).
Three months later the share price recovered. With the shares trading at the deal price the return will be about 2.5x (including the interest that was paid at various times along the journey); at today’s share price, about 3x. If the Novatti neo-bank license is awarded and the shares are re-rated, I could end up with a better return in the escrow period than in the previous 10 years combined. By comparison, a NASDAQ index fund would have returned ~5x since 2010.
Among the many lessons to be learned in this journey, the biggest for me was a first-hand appreciation of the unintended consequences of convertible notes for both the entrepreneur and the investors. If the company does not get enough traction, can’t raise capital and the notes do not have automatic conversion at maturity, a very awkward situation results! In the end, I feel fortunate that the founder persevered and I will likely see my capital and some return next year. Where’s the next deal?