Should the interest on convertible notes be paid in cash in some cases?
When startups raise capital from outside investors, one financial structure commonly used is called a convertible (promissory) note. There are several motivations for startups & investors to use this arrangement.
One thing is coming back to bite me, though, and makes me wonder if the terms of it ought to change in common use: conversion of the interest into stock at conversion.
Typically, a note accures interest over the time that it remains a debt. That accrued interest is generally added to the total amount owed by the company to the investor at the time of conversion into equity (assuming a conversion event happens).
The (USA) tax implications for the investor, though, are that the interest gets reported as a 1099 income to the investor. Note that the investor was "paid" this interest in the form of stock (vs. cash), yet the investor must pay in cash for the tax on this "income".
This isn't a terrible problem in those cases where the note is outstanding a year or so, and the amount invested isn't super-large, and the company is eventually a success. BUT, if any of these are the case, there is a hidden cost to the investor.
Example: Assume a $50,000 investment by an angel, with an 8% interest rate. For the investor, there will be $8,000 of accrued interest at conversion (whether via successful equity fundraising, or default conversion if a round is not raised). If the investor is in a 30% tax bracket, this means an extra $2,400 of taxes paid in the year of the conversion.
It might be palatable if the company is a success long-term. However, recently some of the companies I've invested in failed. So not only did I lose my investment, I paid taxes on "income" from those companies - which was "paid" in worthless stock.
Maybe I'm being a cheap bastard; but there's a part of me that wants the ordinary terms of convertible notes to pay the interest in cash if the conversion is in conjunction with a financing.
The "nice guy" part of me says, though, that most of the failed companies are going to have failed to raise a round of equity, so those won't have had the cash to pay the interest anyway. So I'm making a point about a likely edge-case.
But, given that tax season is on me, I'm feeling like maybe this is worth discussing. Anybody else have thoughts on this?
Update, 9 March 2016
Here are two good articles on why convertible notes are a decreasingly-attractive choice for financing structure: