Convertible notes are not just for early-stage startups any more.
These promissory notes, which are structured as debt that convert into equity upon a specific event like a certain date or the closing of a priced investment round, are increasingly being adopted by established companies that have already raised millions of dollars in venture capital.
In the past, these financial instruments have been the province of founders who weren’t sure how to value their companies. If they agreed to sell a fixed percentage of their startup when they didn’t have a lot of customer traction, they might be giving up a lot of upside in their company. Convertible notes allow companies more time to develop their businesses before deciding who gets what.
In recent months, however, more established companies that have already raised priced rounds have raised money via convertible notes. According to the WSJ, Juul Labs, the e-cigarette maker, recently raised more than $700 million in convertible debt to fund its operations. NeueHouse, a venture-backed nine-year-old, New York-based company that provides workspace to creatives is in the process of raising $15 million in convertible debt, shows an SEC filing. And a crypto exchange that has raised several rounds of venture funding, LedgerX, just closed on $3.8 million in debt.
Why would these older companies want to steal a page from the early-stage startup handbook? Because they want to avoid the negative blowback that might result from a “down round” or a round that establishes a valuation lower than the previous valuation.
VCs don’t like down rounds as it means “writing down” the holdings in their financial statements to their own investors. Down rounds can also publicly signal that a startup’s growth is slowing or hammer home the fact that investors overestimated how much their original stake was worth.
Convertible notes are a convenient band-aid, giving companies a little breathing room to fix their products, search for possible buyers, or move into a different space if what’s plaguing them applies more to their industry than their specific products or services.
From all outward appearances, the e-cigarette maker Juul definitely needs some time to get its ducks in a row. The company is under growing regulatory and financial pressure from investigations into its marketing practices and mounting lawsuits by a growing number of school districts and counties (among them, the Ceres Unified School District, outside of Modesto; the Monterey Peninsula Unified School District; and Bucks County, Pa.)
While Juul once seemed like such a sure bet that Altria purchased a 35 percent stake in the company for $12.8 billion, Juul’s future is now a lot less clear. On January 30th, Altria marked down the value of its stake by $4.1 billion, and it now values the entire company at just $12 billion, a 68 percent decline from the original valuation that Altria ascribed to Juul when it invested.
According to the WSJ, the $700 million will only convert to equity if Juul’s next round values the company between $10 billion and $25 billion. If the valuation of the next round is lower than $10 billion or higher than $25 billion, the $700 million will be treated as debt.
Why it was structured this way: The lower valuation protects investors from holding mere shares in a company whose value is plummeting; in this case, it would be much better to have control of a solid company asset (think the receivables, computers and real estate that secures the debt). Conversely, the higher cap gives investors the assurance that their equity will not be unduly diluted by an unrealistically high valuation from a new investor.
If all goes well, investors benefit because their money converts into equity at a discount to the price paid by the next investor. It’s more exciting than receiving just a straight percentage on their money, which they would earn with traditional debt.
And in some sense, the use of convertible notes by later-stage companies can be viewed as a positive sign. After all, if these companies were irretrievably broken, they wouldn’t be able to raise any money at all.
Still, it’s a desperate look for Juul in particular. In 2018 it was considered to be among the most highly valued private companies in the world.
It suggests that the company’s future is so unpredictable that it can no longer satisfy the requirements of traditional lenders, which insist that borrowers meet a broad array of financial milestones, like hitting revenue targets and maintaining minimum levels of cash on hand.