Convertible Notes as I.O.U.s

TL;DR — For startups, convertible notes suck as they enable tepid investors to double dip. After decades of abuse by VCs, Sharks and so-called Angels alike, it turns out the way founders have been using convertible notes is all wrong. Convertible notes should be used as “I.O.U.s” to service providers for service rendered, in lieu of cash. After all, a convertible note is fundamentally an I.O.U. However, instead of indebted to a shark, a startup would be indebted to someone who performed some service for them.

Introduction — Why Startups Need To Raise Money

Startups need to raise money in order to pay for services. Whatever services a startup needs, the startup needs to pay for it. Generally a startup will pay for services in cash. However, there are some instances where startups can pay for services through less conventional approaches. In 2004, Sean Parker of a startup called Facebook persuaded artist David Choe to take Facebook stock instead of the $60k in cash he would have charged for painting the walls of Facebook's first office. Fast forward and that stock is worth $200 million.

Yes, we started out with a 1-in-100M example of a service provider accepting stock in an early stage startup in lieu of cash. Every example works better if we show how service providers can roll the dice on startups and win. Now that we know that service providers CAN be compensated in stock — why are they not offered I.O.U.s by founders?

Convertible Notes Are I.O.U.s

There are seven types of convertible notes — mandatory, reverse, packaged, contingent, foreign currency convertible, exchange bond, and synthetic bond. The common denominator is that they're all some sort of debt instrument. However, the specific terms vary depending on who is using them and for what. Which is why we have to give you a disclaimer here to remind you to retain a lawyer or counsel who can navigate you through the specifics of your deal. The purpose of this article is for education and your awareness of the art of the possible. Did you know it's possible to convert a service provider's invoice or estimate into a convertible note?

I can already hear the howls of traditional sharks lambasting the abomination of someone innovating on their predatory tradition. A convertible note is fundamentally an I.O.U. — an indisputable fact. What is at dispute is who has the moral authority to issue them and to whom. Traditional sharks will insist that only a shark can offer a convertible note to a startup. That way, a shark can hedge their risks and if the startup beats the startup odds, the shark could then convert their debt into equity at a 20% or more discount.

The question then becomes: why can't startups offer service providers I.O.U.s for services rendered in lieu of cash? After all, the only reason that startups raise capital is to have the funds to pay for services.

We will immediately agree that convertible notes are not some magic funding panacea that alleviates a startup's need for cold hard cash — for payroll, for example. Too, the majority of service providers won't accept I.O.U.s from startups because of the high failure rate (north of 95%). However, as founders, you have an obligation to be creative and devise the propositions that get your startup what it needs. So — have you ever offered a service provider an I.O.U. for services? Or to put it in more technical terms: have you ever asked a service provider to convert their $60k or $600k invoice or estimate into a convertible note? Why not? It's as good as cash. Just ask any shark.

Convertible Notes & Taxes

Disclaimer: This is not tax advice. I am not a CPA, accountant, tax advisor or tax lawyer. Though I teach at a law school it in no way qualifies me to provide any type of advice, much less tax advice. I recommend you retain a qualified tax and legal professional to help you navigate the variables of your unique situation.

Using the Facebook and David Choe $60k example as background, let's turn the scenario on its head. Instead of Facebook, let's use Clubhouse. Suppose Clubhouse gave David Choe a $60k convertible note for painting Clubhouse's offices. At the height of the pandemic, Clubhouse was valued at $4B. Had David Choe accepted a $60k convertible note from Clubhouse, what would it be worth now that Clubhouse is dead?

Clubhouse had two funding rounds — May 2020 raising $10M at $100M valuation, and December 2020 raising $100M at a $1B valuation — ultimately hitting $4B in April 2021. Now had David Choe painted Clubhouse's office for a $60k convertible note, one may think the next questions were: What were the terms of the note? When did it mature? At what valuation? What was the interest rate? What was the discount? Those are not the questions to be asking. The real question is: if you're a service provider, why haven't you ever offered to convert your $60k or $600k invoice or estimate to a startup into a convertible note?

Conclusion

All investing is risky. It's only hindsight that tells us with any degree of certainty who the winners and losers are. However, even in hindsight, winning and losing can get really fuzzy. Just look at Adam Neumann and WeWork — valued at $47B at its height, went bankrupt, yet Neumann pocketed nearly $2B in cash.

The fuzziness of end-stage capitalism aside, if you're an early stage startup, consider offering service providers I.O.U.s. Just call them convertible notes and write terms that are attractive to these Service Provider Investors (SPIs) and less predatory than those that the sharks will give you. Conversely, if you're a service provider, consider inquiring if a startup is willing to turn your $60k or $600k invoice or estimate into a convertible note.

Think on it and may the odds and the algorithms forever be in your favor.