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Updated August 29, 2023You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
Angel investors used to complain that convertible notes prevented them from getting fairly compensated for taking on the added risk of investing in a very early-stage company. A priced round by contrast would allow them to lock in a low cost for their shares. With the popularity of the valuation cap* as a feature of the convertible note, that argument has largely been addressed; but some investors still do not like notes.
From an investor’s point of view, sometimes convertible debt can be better than a fixed price equity round, because:
Debt sits on top of equity; meaning, if the company goes defunct, debt holders are entitled to be paid first, before equity holders.
Noteholders can have favorable conversion provisions, such as discounts and caps.
Noteholders can charge interest.
Noteholders can have warrants appended to their notes as an additional benefit of investing, if that is part of the deal.
Debt documents can contain “event of default” provisions, entitling the holder to declare the note in default and demand payment in cash in full. (In contrast, it is rare to be able to demand the repurchase by the company of your stock, and even if you have that right, state insolvency laws might prohibit the redemption of your shares.)
Noteholders can charge higher rates of interest when the note is past due or the company is otherwise in default on the terms of the loan.
Noteholders can take a security interest in the company’s assets.
Noteholders can have the right to optionally convert if the company raises money in a non-qualified financing at a lower than expected valuation.
Noteholders can still obtain standard contractual rights, such as a board seat, observer rights, participation or pro rata rights, information rights, and so forth.
In other words, with notes, you can do just about everything you could imagine, all in a relatively short document.
If you invest in a convertible note that bears interest, depending on the circumstances you might be forced to take this interest into income on an accrual basis even though you don’t receive any cash payments of interest. How could this be, you ask? Well, because the IRS has rules in place that force note holders in certain situations onto the accrual method of accounting when it comes to interest on private company convertible notes. What happens if the interest is converted into stock? Well, the IRS will still tax you on the interest, even though it is paid in stock.
For most angel investments in convertible notes, this interest income problem is not that big of a deal, because the total interest amount that you might be forced to take into income doesn’t add up to much.
danger But beware if you are investing a considerable amount of money. The tax on the interest income might turn out to be more than you wanted to bear. In these cases, you might want to ask the company to pay the interest in cash so that you can pay the tax on this interest income.
Notes are not required to bear interest if the lender is not related to the company. Thus, another possibility is—just don’t include an interest rate in the note.