Convertible Notes: Best Practices and Trends for Today's Valuation Experts
Convertible notes are a prevalent tool that valuation professionals must navigate when assessing the financing strategies of early-stage startups. While convertible notes streamline fundraising by deferring complex equity negotiations, they also introduce potential challenges in valuation and accounting. This article delves into the hurdles that valuation professionals may face when working with convertible notes, highlights best practices for effective management, and explores current trends that are reshaping their use in the financial landscape.
Why Startups Prefer Convertible Notes
Convertible notes are popular among early-stage startups and investors because they offer a faster, more streamlined alternative to traditional equity financing. For valuation professionals, understanding the appeal of these instruments is crucial for accurate assessments. Startups can secure capital quickly without the need to establish a complicated valuation upfront, which often complicates the valuation process. For investors, convertible notes provide flexibility, particularly during economic uncertainty. Rather than locking in an equity price immediately, investors can wait until the company matures—often during a later funding round—before converting the note to equity. This delay has implications for valuation professionals, who must be prepared to reassess the evolving value of the convertible notes as market conditions and company circumstances change.
Potential Challenges
A significant challenge for valuation professionals dealing with convertible notes is the complexity of valuation methods, including scenario-based assumptions often combined with simulation models. Scenario-based assumptions involve analyzing the outcomes in a limited set of predefined scenarios—such as new funding, mergers, or dissolution—and assigning probabilities to each. This requires a close interaction both with the management team as well as auditors to smooth out the impact of assumptions and valuation outcomes especially in relation to past and future any potential valuation analyses of the company (such as a 409A valuation). Each scenario considered may involve Monte Carlo simulations to evaluate outcomes more objectively by accounting for a range of possible future events, such as the company’s future valuation at the time of a new financing event. Due to the complexity and attention to detail needed, valuing convertible notes could be more time-consuming and expensive compared to conventional valuations. In addition, this requires valuation professionals to navigate the balance between cost, accuracy, and auditor requirements. Failing to meet the auditor’s expectations on time can lead to even higher costs and delayed financial reporting.
Evolving accounting standards present another challenge for valuation professionals working with convertible notes. Previously, a one-time valuation at the note's issuance often sufficed. However, current accounting standards necessitate the fair value election and annual mark-to-market valuation updates, increasing the burden on valuation professionals to regularly reassess the note's value based on market conditions and financial events. This shift complicates the valuation process, as professionals must justify these updates retroactively, making it both time-consuming for the valuation professional and costly for the company. For those who delay valuations until an auditor is involved, the process can become even more intricate and expensive, particularly when multiple years of valuations must be addressed at once.
Best Practices
While the potential challenges of managing convertible notes can seem daunting, following a few best practices can help valuation professionals navigate the complexities effectively, minimize potential pitfalls, and ensure exceptional service.
Conduct valuations proactively: Performing valuations at both the issuance of the convertible note and at the end of each fiscal year is crucial. A proactive approach minimizes last-minute complications, enhances credibility, and helps manage costs effectively by avoiding retroactive work when auditors step in.
Choose the right valuation model: Selecting the appropriate valuation model is essential. More complex notes may require simulation models, while simpler notes might benefit from a less expensive approach. The right model balances accuracy and cost, ensuring that both the valuation professional and their clients are satisfied with the results.
Document assumptions early: Clear documentation of assumptions—such as the probability of future events like new financing, M&A, or dissolution—is vital for valuation professionals. Well-documented assumptions streamline the valuation process and reduce friction during audits.
Build strong relationships with auditors: Developing a solid rapport with auditors is often overlooked but essential in convertible note valuations. Valuation expert Hong Yoo says, “Complex valuations like convertible notes require a lot more interaction with auditors, it’s kind of like a soft skill you need to develop.” Valuation professionals should aim to balance technical precision with a cooperative attitude to ensure a smoother review process.
Current Trends
For valuation professionals, staying informed about current trends shaping the use of convertible notes in the marketplace is essential.
The shift to mark-to-market valuation practices is becoming the new norm, requiring experts to adapt their methodologies and maintain continuous engagement with clients to ensure accurate assessments. Yoo notes, “I think amortization of debt is completely out the door with auditors, so they will expect the fair value election with market-to-market practices, which is technically correct under the accounting standards… which makes it a recurring project because they don't want the burden of saying what's the value of the convertible note on the balance sheet. They want the appraiser to be responsible for it, and correctly represent the note value on the balance sheet until the notes are repaid or converted.”
Another emerging trend is the increasing adoption of convertible notes by late-stage companies. Once primarily utilized by early-stage startups, larger companies are now leveraging convertible notes as a flexible financing tool, particularly in uncertain economic times when locking in equity terms can be challenging. This shift requires valuation experts to refine their approaches and expand their expertise to address the unique complexities associated with later-stage convertible note valuations.
Conclusion
Valuing convertible notes can present unique challenges for valuation professionals. However, by adopting proactive approaches, selecting the right models, and fostering strong relationships with auditors, professionals can navigate these complexities with confidence. As trends like mark-to-market valuations and increasing adoption of convertible notes by late-stage companies reshape the landscape, staying ahead of these developments enables valuation professionals to provide the best service possible.