Convertible Notes have a clause that the investor can ask for the money back. How often is this used?

David S. Rose , Founder and CEO , GUST INC.

25 Oct 2012

The question should be “used for what?”

Because convertible notes are designed to give investors an equity interest in a company that will eventually be worth much more than their investment, the intention on their part is always to convert into equity (after all, if they were just after the interest on a loan, they could find much less risky things to invest in than a startup.)

Therefore, the only reason that an investor would NOT convert into the next round of equity would be if the company was doing so poorly that there was no such round. (Think about it this way: assuming a convertible note with a valuation cap, which is what all smart investors would do, it would always be to the investor’s advantage to convert, regardless of whether the valuation of the round was high or low.)

But the flip side of this is that if the company is doing so poorly that it can’t raise another financing round, it is also highly unlikely that it will have the cash on hand to repay the debt, so there would be no purpose to be served by the investor asking for the money back…because they couldn’t get back what doesn’t exist.

So therefore, if the repayment clause is not used to get the money back, what is it used for?

It is used as an incentive (carrot/stick) for the investor and the company to sit down for a heart to heart talk, and figure out what to do next…with the balance of power this time in the hands of the investor, because the company was not able to deliver on its projections.

• If things are generally going pretty well, the investor(s) will usually extend the note to give the company more breathing room, maintaining the status quo.
• If things are going not so well, and it doesn’t look like there will be a follow-on financing round any time soon, the investor and company might agree to convert the note into equity at a previous (lower than anticipated) valuation (if there had been a previous round) or at whatever valuation they agree on.
• In a worse case, if the company is really in bad shape, the investor can pretty much dictate whatever terms s/he wants, using the implied threat of otherwise forcing the company into bankruptcy because it can’t repay the debt.

While that last option sounds pretty horrendous, in practice I have seen it used mostly for good. There are many permutations of what “good” could look like, but essentially holding a past-due note from a company that can’t repay it, is like holding a nuclear weapon: using it probably destroys all value for everyone, but the ability to use it, like the geopolitical theory of Mutually Assured Destruction, means that everyone is at least forced back to the table to negotiate a way of saving the company.

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