Big Red Car here. Well, The Boss is away and me and the housesitter have been having a bang up time. That boy can really party!
So The Boss was talking to one of his brilliant CEOs and they got into the issue of the appropriate role for investors when the investment vehicle is a convertible note.
The distinction being made is between an equity investment and a debt investment. One creates shareholders and the other — the convertible note — creates lenders. They are decidedly not the same thing.
This distinction is irrelevant most of the time as the entrepreneur, founder is likely to be disposed to treat investors the same regardless of whether they are technically lenders or shareholders. This is a very difficult issue sometimes when the entrepreneur, founder and the investor may not agree on a matter of some importance.
1. A shareholder is entitled to some very special consideration as they are the actual owners — in conjunction with all other shareholders — of the company. They own the company.
2. Lenders are not entitled to any consideration other than that spelled out in the promissory note or in a loan agreement. It is not unusual for a savvy investor to ask for certain considerations in a loan agreement and an entrepreneur, founder must live up to those covenants.
When a venture capitalist — who is conditioned by nature to be involved in every aspect of a company in which they have invested OPM — is the provider of funding through a debt instrument (convertible note) this can become a bit dicey as they are not “entitled” to any consideration or participation in the management of the enterprise other than that spelled out explicitly in the actual note or accompanying loan agreement.
Many companies use a convertible note when they are very young and are in the bootstrap, friends and family, angel, syndicated angel or seed phases of their life. A convertible note is often used when it is virtually impossible or awkward to arrive at a useful or attractive “pre-money” valuation of the enterprise. Everybody knows this going into the investment.
What is not discussed sufficiently is the role of a lender in the management of the enterprise. When the note or loan agreement is silent on this matter — as it is more often than not — then the lender is essentially entitled to no special consideration other than that of a lender.
A lender would therefor not appropriately be an active participant in the discussion of the management of the enterprise and in perhaps some very big decisions. Mother Nature would suggest the lender would want to be involved but that is not the nature of a lender’s role. When that role is violated and lenders do participate in the management of an enterprise they are arguably setting themselves up to be considered as a partner rather than as a lender. This is a legal role arguably fraught with peril.
The bottom line is this:
1. Entrepreneurs, founders need to carefully consider the role they want investors to play in the management of their enterprise when the investment vehicle is a convertible note. Enter into an agreement using either the note itself or a loan agreement which codifies and sets forth this arrangement. Do not be afraid to suggest the lender plays no role in the management of the enterprise.
2. Venture capitalists and other sophisticated investors must limit their participation to the role specifically granted to them by the same documents though their natural tendency may be to take a far more active and intrusive role in an equity investment. They must maintain the distinction and differences.