Convertible Notes for Angel Investing

How it started

In response to the wash out and cram-down rounds the angels (and entrepreneurs) suffered through in the early 2000's, early-stage investors started looking for a better way to structure their investments.

At most angel meetings in 2004, the most popular structure discussed was the convertible note.

This was conceived as a way for angel investors to invest with some protection against the terms and pricing negotiated with traditional venture funds in the subsequent rounds.

The typical convertible note agreement was usually structured so the angel investors received the same type of shares as the VC's, but at a pre-agreed discount to the next round.

This idea provided reasonable protection for the angel investors and was simple and inexpensive to structure.

The pricing problem

The biggest problem with the convertible note concept is the pricing mechanism. The typical discounts to the next round were in the 20% to 30% range. This sounds like a significant percentage, but it is actually far too low to be fair to the angels unless the conversion occurs very quickly after the angels invest.

Angel investors usually invest much earlier than VC's. Even if this isn't that long in calendar terms, it's usually much earlier in terms of the risk and therefore reward.

To be fair to the angel investors, and provide them with a reasonable risk-reward ratio, the percentage discounts need to be much higher. The fair discount range for most angel investments is probably in the 50% to 75% range, assuming the next round occurs in about one year. This percentage is, probably beyond the range most follow on investors would consider palatable.

Next round Investors

If a convertible was structured with a fair discount, the next round investors would probably think the discount percentage was too high. This does not even suggest they are being unreasonable - it's really just due to human nature. Once success has been achieved, it always feels like the risk looking backward was much lower than it actually was.

The negotiating strength of the next round investors is so much stronger than the current shareholders, that they would probably require the discount rate to be reduced to 20 to 30% before they invested their money.

It's not really debt

The convertible note is structured like debt. While this may at first seem reasonable, for practical purposes, it's not effectively debt for two reasons. First because most companies at the angel round don't have enough tangible assets to secure any debt. Additionally, most angel investors just don't have the personalities required to act like debt holders - they usually identify with the entrepreneurs and in most cases are just way too nice to be fair to themselves.

So the angels lose

In almost every situation the convertible ends up not being fair to the angel investors. Either the discount is too low or the fact that it's not really debt means that the next round investors will most likely reduce the angel's returns below a fair value.

Exchangeable shares are much better

We believe there is an improvement on the convertible note concept that retains the advantages, but also solves the pricing problem. It is the Exchangeable Share.

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