Latest / The Startup Exit Podcast with Fexingo: IPOs, Acquisitions, and Founder Liquidity Events / How Founders Use Convertible Notes in Exits
Transcript
- Lucas: So you close a term sheet, the deal is a hundred percent stock, and you think you're done. But there's this piece of paper from two years ago — a convertible note — that's about to decide who actually gets paid at the exit. Luna: I feel like founders forget those notes are still sitting there. They're not equity, but they're not debt either. It's this weird middle zone. Lucas: Exactly. And today we're going to walk through what actually happens to a convertible note when your startup gets acquired. Not the theory — the math. Because depending on how the note was structured, that $10 million exit can leave the founders with a lot less than they thought. Luna: Let's do it. So first, remind me — what's the basic structure of a convertible note? I know it converts to equity at the next round, but what happens at an exit? Lucas: Right. A convertible note is basically a loan that converts into equity, usually at a future financing round, at a discount or a valuation cap. But if there's no next round and the company gets acquired, the note typically converts into equity at the exit price, or it gets repaid with interest. The problem is, many notes have terms that trigger conversion automatically at a qualified financing or at a change of control. Luna: And a change of control — that's the acquisition. So the note converts right at the exit. Lucas: Yes. And here's where it gets interesting. The note's conversion terms were set when the company was young and risky, so the valuation cap might be really low. Say the cap is $5 million. If the exit is at $10 million, the note converts as if the company was worth $5 million, meaning the note holder gets twice as much equity as they would have if they'd invested at the exit price. Luna: So the note holder gets a huge reward for early risk. But that comes out of the founders' and other shareholders' pockets. Lucas: Exactly. And it's not just the cap. There's usually a discount too — often 20 percent. So the note converts at 80 percent of the exit price. Combined with a cap, that can be a double dip. Let's put some numbers to this. Luna: Please. I'm a visual learner. Lucas: Okay. So let's say your startup gets acquired for $10 million. You have a $2 million convertible note with a $5 million cap and a 20 percent discount. The note holder gets to convert at the lower of the cap or the discounted price. The discounted price would be 80 percent of $10 million, which is $8 million. The cap is $5 million, which is lower, so the note converts at $5 million. Luna: So the note holder gets $2 million worth of equity at a $5 million valuation. That means they get 40 percent of the company. Lucas: That's right. Forty percent of the company for a $2 million note. If the note had converted at the actual exit price, they'd get 20 percent. So the cap just doubled their ownership. Luna: And that 40 percent comes out of the common shareholders' pool. So you and your co-founders get less. Lucas: And it gets worse if there are liquidation preferences on top. Many investors, especially in later rounds, have participating preferred stock with a 1x liquidation preference. That means they get their money back before anyone else, and then they also participate in the remaining proceeds. Luna: So the convertible note holder, who might have converted into preferred, could be sitting ahead of the common shareholders in the payout order. Lucas: Right. Now, in practice, acquirers often push to convert notes early, before the deal closes, to simplify the transaction. But the terms of the note might not allow that, or the founder might not want to because it could trigger additional dilution. Luna: So what can a founder do? Are there ways to structure a note to avoid this kind of surprise at exit? Lucas: One common approach is to put a cap on the conversion at exit, so the note holder gets a set percentage of the deal, not the potentially huge amount that a low cap could imply. Another is to require note holder consent for any change of control, so the founder can negotiate a better deal for everyone. But the simplest is to just be aware of the math before you sign the note. Luna: Yeah, because once you're at the exit, you can't go back and renegotiate the note. It's too late. Lucas: Exactly. And that's why we're talking about this today. In the current market, we're seeing a lot of tech stocks with big swings — Shopify is down almost 8 percent this week, Meta down over 8 percent. That volatility can push acquirers to be more conservative, and they might try to reprice deals or adjust the treatment of convertible notes. Luna: So market conditions can actually affect how notes are treated at exit. Lucas: Definitely. If the acquirer's stock is dropping, an all-stock deal becomes less attractive, and they might push for a lower purchase price. That flows through to the note conversion math. So founders need to keep an eye on the market, not just their cap table. Luna: So what's the takeaway for a founder who's holding a convertible note right now and thinking about an exit? Lucas: First, know your note's terms inside and out. Pull out the actual document and look for the conversion triggers, the cap, the discount, and any change of control provisions. Second, model the exit at different price points. See how the note holder's payout changes if you sell at $5 million, $10 million, or $20 million. And third, if you're in active M&A discussions, talk to your lead investor early about how the note will be treated. Luna: And don't be afraid to ask the acquirer how they handle notes. Some have standard procedures. Lucas: Right. Because in the end, the convertible note is a tool that helped you get started. It shouldn't become a trap that undermines your exit. But it can, if you're not paying attention. Luna: And honestly, if this episode helped you think about your own cap table, that's exactly the kind of thing we love hearing. And if you want to support the show, you know where to find us — buy me a coffee dot com slash fexingo. Every little bit helps us keep making these deep dives. Lucas: Yeah, and it's a small gesture that goes a long way. But back to the math — one more thing that founders often overlook is the interest on the note. Notes typically accrue interest, and at exit, that interest is usually converted to equity as well. So the note holder gets even more shares. Luna: Oh, that's a good point. So it's not just the principal, it's the interest on top. That can add up over a couple of years. Lucas: Absolutely. So when you model the exit, include the accrued interest. It could be an extra 10 to 15 percent on top of the principal, depending on the rate and the time period. That's more dilution for the common shareholders. Luna: So the note holder could end up with a significant chunk of the exit, especially if the cap is low and the interest has been accruing for a while. Lucas: Exactly. And this is a real example, not hypothetical. I've seen a $3 million note with a $10 million cap and 8 percent interest over three years. At a $30 million exit, that note converted to nearly 15 percent of the company. The founders were shocked. Luna: Wow. That's a big slice. So the lesson is to always run the numbers before you sign the note, not at the exit. Lucas: Right. And if you're already past that point, at least run the numbers now, before you enter negotiations. Knowledge is power. Luna: So what's the forward look? Are we going to see more or fewer convertible notes in the current market? Lucas: I think we'll see more, actually. With the public markets being volatile, early-stage investors are more cautious about setting valuations. Convertible notes let them delay that conversation. But the risk is exactly what we talked about — those terms can come back to bite at exit. So founders need to be even more careful. Luna: That makes sense. So maybe the takeaway is: love the convertible note, but understand the math. Lucas: Love the note, understand the math. I think that's a great way to put it. For now, that's our exit drill. We'll see you next time.