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[Fundraising] Promissory Notes Vs Convertible Debt?

I'm raising money for an app I'm launching early next year, and most people have advised me to raise the funds as convertible debt with a cap and a discount. One gentleman recently told that he'd prefer seeing us issue promissory notes, which I'm less familiar with. Can someone please explain the difference? What are the consequences to myself and my team if by some chance we are unable to pay back a promissory note?

7 Replies

Steve Everhard
0
0
Steve Everhard Advisor
All Things Startup
A promissory note is really a negotiable bond which can be traded but returns a fixed interest at a determined time in the future. It doesn't carry a convertible component so must be paid in full on maturity. They typically have a shorter term than convertible debt and the final holder may not be the same as the payor. There can be a complex trail of liability for traded notes but the important thing is that they are short term, with fixed interest and payable at the end of the term.
Max Avroutski
1
5
Max Avroutski Entrepreneur
eCommerce, Software Developer, Usability, Marketing & Product Creation consulting services.
Note: I am not afraid of down votes of this post, my post maybe uncompromisingly forthright, but it is correct and to the point.

Promissory note and convertible debt is for weak projects and weak entrepreneurs that can't develop worthy product or not willing to spend time and brain power to find better investors. When you didn't had enough time to create value and therefor valuation is very low or uncertain or you are raising less than $500K-$1M, everyone should only use Convertible Equity where investor buys special equity that will convert at a later date to a preferred or other type of shares at a discount of 10-20% and if your project is weak then investors may require a cap - I personally can't recommend doing cap because it's stupid - it's just a underwater valuation without cost of doing valuation and it defeats the purpose of convertible equity which supposed to give you more time to create value.

Full valuation could cost $50k so on $500k raise you loose 10% of your money just for doing valuation. In the beginning $500k may be more than 100% of your entire venture.

Promissory note is just debt (loan) - down side is that you have to pay interest and when company is sold debt gets paid from the top and all investors share what is left. If loans are a large portion of sale price then loans paid first, and equity holders share what is left and sometimes founders get very little or nothing.

Convertible debt is not better, you have to pay interest which eats into cash flow and investor's money that supposed to grow the company but instead you paying that money back as interest and then you have to deal with nonsense of conversion terms, some may give investor right to demand full payment and liquidation of your company, all depends on what you negotiate. Better not to deal with that nonsense at all.

Just do Convertible Equity with discount and no cap or if you have to settle for a cap do astronomically large cap, because if cap is too small you will end up giving to first investor much more than you thought.
David Still
1
0
David Still Advisor
Founder of Start-ups, Entrepreneur, Financier and Advisor

A promissory note (Note) is a signed document containing a written promise to pay a stated sum to a specified person or the bearer at a specified date or on demand. It is a security as are all the other labels like Promissory Notes, Convertible Debt, Preferred etc., etc., etc. The security is repaid with a return on the stated sum (Return). Don't get confused by the words and/or acronyms and/or 'fast chat' used by "experts." There are only three things than can happen to the Return: it goes up, down or stays the same. Regardless of what the Note is called you simply need to know how to calculate how much the Return will cost you under your worst, best and likely case scenarios. The rest of the yatta yatta is hocus pocus to rip you off aka get more of your money. A few KISS, non-inclusive Rules:


  1. NEVER personally guarantee any Note no matter how it is labeled;
  2. NEVER sign a demand Note;
  3. NEVER let a spouse, family member or friend cosign or guarantee a Note;
  4. ALWAYS ask your lawyer how you can structure the Note to be protected by the Uniform Commercial Code; i.e. statute versus common law;
  5. ALWAYS ask your lawyer if a Note is a legal one if it does not have a specified date or is not on demand;
  6. ALWAYS demand that the agreements stipulate that disputes be remedied at the company's expense by neutral binding arbitration - not litigation;
  7. ALWAYS ask the lender/investor to draft sample "if, then" calculations under the relevant covenant in the agreement no matter how much they squeal and tell you "you don't know what you are talking about";
  8. Never let the lender/investor assignor sell the Note without your written permission - not to be unreasonably withheld;
  9. NEVER secure the note with your house or dog;
  10. NEVER sign anything you do not understand regardless of the pressure and embarrassment - feign a heart problem if you have to;
  11. Other


"In tribal times, there were the medicine men. In the Middle Ages, there were the priests. Today, there are the lawyers and investors. For every age, a group of bright boys and girls, learned in their trades and jealous of their learning, who blend technical competence with plain and fancy hocus-pocus to make themselves masters of their fellow men. For every age, a pseudo-intellectual autocracy, guarding the tricks of the trade from the uninitiated, and running, after its own pattern, the civilization of its day." (adapted from Fred Rodell, Yale,Woe Unto You, Lawyers!)


If by some chance you are unable to pay back a promissory note, then your teammates and you will be in hell for a while - just chill, keep fighting, walking and don't give up -you will still be breathing. Also, be careful using the word 'gentleman' until you have seen somewhat act in a reasonable manner when they are about to lose money.


All and all, it's better not to use other people's money particularly when that 'other person' is using 'another person's money'. Trust me.


Fortuna, David

Steve Everhard
0
0
Steve Everhard Advisor
All Things Startup
@ Max Convertibel debt only accrues interest at the conversion rate - it does;t eat into cash flow. I have never heard of convertible debt that requires interest payments during the term. Promissory notes are short term and so it's unlikely that a sale would impact the note. The biggest problem is whether you have cashflow to support repayment as new investors aren't going to be happy that their investment is used for repaying promissory notes rather than growing the business.

David I'm with you regarding using other funds but sometimes it is unavoidable. You should not be using directors guarantees in the US unless the terms are totally amazing. In the UK directors guarantees are standard terms. Transfer of promissory notes is not normally controlled by the maker but by the payor - it is their debt and they can assign it anyway they like.
Jackson Powell
1
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Jackson Powell Advisor
UI/UX Designer & Front End Developer
Joseph, it sounds like you could benefit from some personalized guidance. Someone like Lonnie Sciambi, an advisor.

Apart from being tried and tested as an investor and entrepreneur like I'm sure the other suggestions are, the benefit of Lonnie is he's accessible to help you on-demand.

He's got a service where you can ask him your toughest question and he'll reply directly with a custom response. Give him a try, it costs you nothing.

thesmallbusinessforce.com/ask
Mindy Barker
0
0
Mindy Barker Entrepreneur
Passionate executive working with entrepreneurial companies to improve profitability, value and cash flow
Whether you issue convertible debt or a promissory note - the consequences to you and your team are the same if by chance you are unable to pay back the money you received. If you personally guaranteed the debt or note, you will have a personal debt to satisfy and have a blemish on your reputation as an entrepreneur. If you do not personally guarantee the debt or note, then you personally do not have the debt, but you do have the costly consequence of a blemish on your reputation. Mindy Barker, CPA [removed to protect privacy] mindybarkerassociates.com *2016 Small Business Leader of the Year - JaxChamber Health Council* *2015 Partner in Philanthropy Honoree, Jacksonville Business Journal*
Max Avroutski
1
0
Max Avroutski Entrepreneur
eCommerce, Software Developer, Usability, Marketing & Product Creation consulting services.
@ Steve
I agree that it's not common to see periodic payment requirements of accrued interest on Convertible debt nowadays, but it's very easy to put them there. And that is where danger for novice entrepreneur exists from overbearing or novice investor.

Also, most non-investors i.e. people that don't have vested interest agree that Convertible debt is double dipping by asking for both interest and equity on top of getting to be senior to all equity positions. In contrast, you don't get interest on the money you spent to buy equity in addition to equity itself - that would be ridiculous. So, since Convertible debt is just a transitory instrument to get equity without doing costly or premature valuation then it stands to reason that the application of interest is inappropriate vestige of putting two concepts together a) a "loan" and b) "purchase of equity" and as you know it is being phased out from market in favor of Convertible equity.
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