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What Happens If Convertible Notes Are Called By Angel Investors?

Q: Convertible notes are popular instruments for angel investors when a future VC round might occur. But, if it takes longer to get to the venture round than you thought (doesn’t it always?) what happens when the note comes due? Can one investor call the note and put you out of business?

A:  (Jason).  Yes, technically they can, but in practice this rarely happens.  Normally, one of two situations exist:

1.  the company is doing “okay” just behind in it’s fundraising and it will get funded; or

2.  the company is not going to get funded and it’s realistically done.

In case one, the investors would be irrational if they called their notes, as they would get pennies on the dollar (remember the company is spending their money along the way) and preclude any chance of funding and thus them getting an attractive return.  Even in cases where funding seems remote, most of the time investors will give the company the maximum opportunity to get funded and continue on. 

In case two, the company is going to shut down probably, so it’s probably not too traumatic to call the notes.  In any event, the investors will get back pennies on the dollar, so it’s still in the best interests of the investors to let the company run as long as possible before throwing in the towel.

One thing to note:  don’t personally guarantee angel notes.  In that case, the calling of the notes will attach to the entrepreneur’s personal assets and may indeed incentivize investors to call their notes sooner than later.

December 10th, 2007 by     Categories: Angel Investing, Debt, Fundraising    
  • http://venturehacks.com Nivi

    Another possible approach:
    Agree to convert the debt to common or preferred stock at a predetermined valuation if there is no financing before the maturity date.
    More here: http://www.startupcompanylawyer.com/2007/04/29/what-happens-to-the-convertible-promissory-note-if-the-maturity-date-is-reached-and-there-hasnt-been-a-financing/
    And here: http://www.venturehacks.com/articles/debt-microhacks

  • http://www.altgate.com Furqan Nazeeri

    There is a scenario where the company captures lightning in a bottle and a greedy angel calls the note in order to either take another bite at the apple in terms of pricing or to just outright take the assets of the company (remember the note is probably secured against all assets and even if there is no cash in the company someone could go after a very valuable asset). You can try and craft legal language to protect yourself against this, but it’s a low likelihood scenario and the best thing is to do diligence on your investors and make sure you know they’re not the kind of folks to do this.

  • http://www.awhere.com Jim Pollock

    Excellent post. Our company has raised several hundred $K of Angel money with a convertible note. We were a little afraid of this same scenario.
    Jason’s point about there being two scenarios is true: either things are going great.. or things suck. If great, they aren’t going to call. If things suck, the note holder already has a built-in safety. If the company does a fire sale of IP or whatever, by law the debt-note holder has a higher preference of repayment over any stock holder including founder or preferred stock (isn’t that right, Jason? That’s how we understand it.)
    Also, it is important to make your investors understand that for technology startups, the convertible note is a “debt instrument” towards ultimately an equity play. It is NOT a traditional debt note that is INTENDED to be paid back as such. For example, where many debt notes or bridge loans are intended to be short term and repaid, the term of the note is often 3 or 6 months. The term of our note is two years. As a startup we KNEW that 6 months or 1 year from the note-date would be an “exciting time” and we didn’t want to deal with the possibility of a “call” that soon.
    We had a few investors question the length of time, since they were more familiar with short-term bridge loans. Once we explained and amplified this point, it made since and we had no problem getting the deal.
    When done right, convertible notes can be powerful instruments for both the investor and the startup.
    Jim

  • Knox Massey

    1.) I’ve never seen a note called. Believe me, angels don’t want to call the note. They want the company to succeed!
    2.)The note should be backed by the IP of the company. It’s usually the only asset(if any). The angel is taking the risk of investing his/her money. The entrepreneur is taking the risk that they will be able to raise institutional capital.
    3.) I’m not a big fan of convertible notes these days. Everyone is using them and *everyone* will, unfortunately, not be able to raise that “A” round. (Come on already, value the company!)

  • http://www.kratylos.com Christopher Bader

    I’ve been hearing different things from different investors about convertible debt. Is it preferable to convertible preferred stock?

  • http://franchiseinvestment.wetpaint.com/ angel investor

    I have heard a lot from different investors.I’m a big fan of convertible notes these days. Everyone is using them in these days.

  • http://franchiseinvestment.wetpaint.com/ franchiseinvestment

    Jason,
    I think you are right in your answer I agree with with your solution.
    Thank you.

  • T Gupta

    Hello There!
    What are the different types of convertible notes that are suitable for technology company to as an Angel investor?
    Is it reasonable to expect the company be in a position to issue stock at the time the note is first used as an instrument to raise the very first round of capital?
    I really appreciate your response.
    Thanks,
    T. Gupta