How Startups Can Use Convertible Notes as IOUs
By Samson Williams
TLDR; For Startups convertible notes suck as they enable tepid investors to double dip. Too, 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 (owe) 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 not so novel or not so unique approaches. For instance, 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-a-100M example of a Service Provider (an artist in this instance) accepting stock in an early stage startup in lieu of cash. Alas, every example works better if we show how Service Providers can roll the dice on Startups and win a 1 in 100M odds.
Now that we know that Service Providers (e.g.: accountants, economists, artists, project managers, general contractors etc…) 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. DYK - its possible to convert a Service Provider’s invoice/estimate into a Convertible Note?
I can already hear the howls of traditional Sharks lambasting the abomination of someone “innovating” on their predatory tradition. As such we’ll address their laminations first and foremost by acknowledging that a Convertible Note is fundamentally an I.O.U. Convertible Notes being I.O.U.s are 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 beat the startup odds, the Shark could then convert their I.O.U. (debt) into X% equity into the Startup at a 20% or more discount.
The question then becomes, why? Why can’t Startups offer Service Providers (modern day David Choos) I.O.U.s for services rendered in lieu of cash? Afterall, the only reason that Startups raise capital is to have the funds to pay for services. Yes, we will immediately agree that convertible notes are not some magic funding panacea that alleviates a Startup’s need for cold hard cash; e.g. for payroll. Too, the majority of Service Providers won’t accept I.O.U.s from Startups because of the high failure rate of startups (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 in a more technical sense, “Have you ever asked a Service Provider to convert their $60k or $600k invoice or estimate into a Convertible Note?” Why not? Its 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 Choo $60k example as background, lets turn the scenario on its head. Instead of Facebook let use Clubhouse. Suppose Clubhouse gave David Choo a $60k convertible note for painting Clubhouse’s offices…? As a reminder at the height of the pandemic Clubhouse was valued at $4B. Why investors thought that an even worse version of a Zoom partyline would last, much less be profitable, once lockdown ended was and remains a mystery. At any rate, had David Choo accepted a $60k dollar convertible note from Clubhouse what would it be worth now that Clubhouse is dead?
Hence, why this is a tax question with a variety of variables. Clubhouse did have two funding rounds in May 2020 raising $10M at $100M valuation and December 2020 raising $100M at a $1B dollar valuation. Ultimately hitting a valuation of $4B in April 2021. Now had David Choo painted Clubhouse’s office for a $60k convertible note (in lieu of cash) one may think that the next set of questions were: What were the terms of the note? When did the note 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/estimate to a Startup into a convertible note?”
All investing is risky. Its 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 Neuman and WeWork. WeWork was at its height valued at $47B dollars, went bankrupt and yet Neuman pocketed nearly $2B in cold hard 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/estimate into a convertible note.
Think on it and may the odds and the algorithms forever be in your favor.
About The Author
Samson is an internationally recognized anthropologist for his work in monetizing the social and cultural drivers of digital economies; specifically for blockchain, cryptocurrencies and the Space Economy. While Samson is ranked among the globe’s top innovative technology professionals for his cutting-edge research and applications in crowdfunding, tokenomics and digital securities you should take everything he says with a grain of salt, as he is first and foremost a landlord. When not collecting 40% to 60% of people’s hard earned money via rent, Samson is a professor at the University of New Hampshire School of Law, Instructor at Columbia University and Partner at MilkyWayEconomy, Washington DC’s premier Space think tank and VC firm. For business inquiries Samson can be reached on social @HustleFundBaby.