Drawbacks to Convertible Notes

Drawbacks to Convertible Notes

May 9, 2022 by investor

Drawbacks to Convertible Notes

Convertible notes are often used by startups in the early stages of fundraising as they are fairly simple to use and need little legal work compared to equity agreements.

There are drawbacks one should know. 

Here’s a short list to consider:

Convertible notes are not equity agreements and do not qualify for tax deductions such as Section 1202.

Most investors prefer equity over convertible notes and will be more willing to sign up for an equity deal structure.

The note is a form of debt that could be used to reclaim the funds in case of default.

The interest that accumulates from the note should be reported on the investor’s tax return and taxes paid, even though the interest was never paid out.

Convertible notes without valuation caps can be a problem for investors down the road as the conversion will be set by the follow-on equity funding.

Finally, most convertible notes don’t define all the terms as a standard equity agreement which includes board seats, voting rights, and more. 

Convertible notes are often used as a placeholder for fundraising ’til the lead investor is secured, at which point the convertible note for investors convert to equity.

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Hall T Martin is the director of Investor Connect, which is a 501(c)(3) nonprofit dedicated to the education of investors for early-stage funding. All opinions expressed by Hall and podcast guests are solely their own opinions and do not reflect the opinion of Investor Connect. This podcast is for informational purposes only and should not be relied upon for the basis of investment decisions.