You didn’t plan for it to happen this way but you’re reaching the maturity date (end of term) on your convertible note and didn’t raise money in an equity round to cause a natural conversion (called a “qualifying transaction”). Your options are somewhat limited. You could try to complete the qualifying transaction, even if the terms are terrible. Yikes. You could talk to your attorney about offering to convert the note holders to equity using the Valuation Cap as the pre-money valuation. Not bad. Or you could request that your note holders give you more time by approving an extension to the maturity date. Hmm, is that even possible? Yes, and it’s the option I want to explore further in this article so that you can see the investor’s point of view and decide how to best handle.
In my article titled “Convertible Note Basics“, I describe the various terms that exist in most convertible notes. The term that usually gets the most attention and argument is the Valuation Cap (see related article titled “Justifying the Cap Amount in Your Convertible Note“). Often times, the maturity date is mostly ignored. 18-24 months is a very common term and it’s the period of time in which the company has to raise money that meets the criteria of a Qualifying Transaction so the note holders can convert their investment into equity. If you don’t give yourself enough time or if you continue to raise future rounds of funding using new convertible notes, you could reach the end of the term and be faced with some really important decisions.
My personal pet peeve with extension requests is when startups don’t feel like the request isn’t any big deal and should just be rubber-stamped. Depending on the terms in the convertible note, granting an extension to the maturity date can change the economics to the investor. I realize most startups are naïve to these issues, which is why I wrote this article. Below are my thoughts on the matter, assuming you want to extend the note by 6 months or more (a short 60-90 day extension request is probably just a bridge to an equity investment round that is in the very late stages of completion).
Make Sure You Intend to Raise an Equity Round Before the Maturity Date
This might be an obvious statement and won’t necessarily be helpful if you’re reading this after already having raised money on a convertible note and now are approaching the maturity date. Essentially, you should give serious thought to this when you initially raise money on a convertible note, which is a debt instrument. I know it requires looking into a crystal ball, but if you have no idea when you might be in a position to raise a future equity round, then consider including a 24 month or longer term to give you plenty of time (hopefully). This might cause the investors to ask for a higher Discount because of the amount of runway you’re giving yourself, but maybe that’s OK because of the additional flexibility you have on the timing of the future equity round. And if you have a reasonable valuation cap in your convertible note, the investor already has high-side valuation protection.
Investors Aren’t Excited About the Interest Rate
You might be inclined to say “We’d like you to approve a 1 year extension on our convertible note but we’re still going to let you accrue 7% interest”. Not good enough. Early stage investors want to get a preferred class of equity in the company in hopes of an attractive exit via acquisition or IPO. They aren’t investing for interest accrual, even at 7%. You could agree to increase the interest rate to 10-12% (for example) for the extension period, and that would be a very nice gesture, but as you continue to read on you’ll realize this isn’t the biggest issue to address.
You Might Get Acquired During the Extension Period
Pet peeve #1. Many convertible notes have a term that gives the investor a 2X payback in the event of an acquisition before the note naturally converts to equity. It’s called a Change of Control provision. If you ask the investor to extend your maturity date, you’re also giving yourself more time to be acquired. The investor isn’t hoping to only get a 2X return on their investment and won’t be happy if the extra time they’re giving you allows an acquisition to happen. The real issue comes if acquisition is very attractive to the company. The investor could/should have gotten a 4-5X return (for example) but because of the way the Change of Control term was written, all they get is 2X.
Many convertible notes have a term that gives the investor the option to convert to equity using the cap amount as the valuation if there’s an acquisition. This addresses the concern because the investor can either convert to equity in conjunction with the acquisition and get their pro rata share of the proceeds or they can get a 2X return, whichever is better for them. But if you didn’t have this option in your original convertible note, you certainly should consider adding it when you ask the investors for a maturity date extension.
Surely There’s a Valuation Cap in the Note
Pet peeve #2. If your convertible note didn’t originally have a valuation cap, you definitely should consider adding one when you request a maturity date extension from the investors. Otherwise, you would be asking them to give you more time to execute and justify a very high valuation in the future when they do convert, yet they are the ones that would take the dilution hit as a result. Not fair.
Even if you do have a valuation cap in your note, your request for an extension gives you a higher chance of converting the note holders at that cap amount versus having the discount come into play. Investors prefer to get their discount and originally treated the valuation cap as a “high side” scenario. With your extended term the cap becomes a more likely scenario. I guess you could consider offering a higher discount in conjunction with the extension request. The main thing to remember is that the Discount and Valuation Cap terms are in convertible notes to reward for early investments when the opportunity and potential return is much more risky.
Converting to Common Class Equity
Many convertible notes allow the investor to convert to equity if the maturity date is reached. So that seems like an easy remedy, right? Well, since you don’t have a preferred class of equity for them to convert into, it means they have to convert to common class equity. Some investors might choose this path but most will strongly want the extra rights that accompany preferred equity. Things like a liquidation preference (probably the most important right), pro rata investment rights, special voting/blocking rights on certain important company decisions, and more.
If you have done a good job communicating with your investors before now, you should have an easy time describing your need to extend the term on your note. If not, then you’ve got extra work to do. Your note terms might say you only need approval from a “majority” of investors (or majority of amount invested). But I strongly recommend you talk with as many investors as possible so you can hear their questions, concerns and recommendations. Be prepared for the topics described in this article and you’ll be in good shape.
See my related article titled “How Much Should You Raise?“