Dec 10 2007

What Happens If Convertible Notes Are Called By Angel Investors?

Q: Convertible notes are popular instruments for angel investors when a future VC round might occur. But, if it takes longer to get to the venture round than you thought (doesn’t it always?) what happens when the note comes due? Can one investor call the note and put you out of business?

A:  (Jason).  Yes, technically they can, but in practice this rarely happens.  Normally, one of two situations exist:

1.  the company is doing “okay” just behind in it’s fundraising and it will get funded; or

2.  the company is not going to get funded and it’s realistically done.

In case one, the investors would be irrational if they called their notes, as they would get pennies on the dollar (remember the company is spending their money along the way) and preclude any chance of funding and thus them getting an attractive return.  Even in cases where funding seems remote, most of the time investors will give the company the maximum opportunity to get funded and continue on. 

In case two, the company is going to shut down probably, so it’s probably not too traumatic to call the notes.  In any event, the investors will get back pennies on the dollar, so it’s still in the best interests of the investors to let the company run as long as possible before throwing in the towel.

One thing to note:  don’t personally guarantee angel notes.  In that case, the calling of the notes will attach to the entrepreneur’s personal assets and may indeed incentivize investors to call their notes sooner than later.