What Happens to a Convertible Note if a Startup Fails?

A convertible note is a hybrid financial instrument, blending debt and equity. It begins as a loan to a startup, with the understanding it can convert into an ownership stake at a later date, typically during a future funding round or acquisition event. This structure allows early-stage companies to secure capital quickly without immediately determining a valuation, a process that can be complex for young ventures. Convertible notes often include an interest rate, maturity date, valuation cap, and discount rate, influencing eventual equity conversion.

The Nature of Convertible Notes in a Default Scenario

A convertible note is a debt instrument until it converts into equity, carrying obligations like principal repayment and accrued interest. Startup failure can include insolvency, formal bankruptcy proceedings, or an inability to raise further capital. If a startup cannot meet its financial obligations or achieve a qualified financing round, the note’s debt features are activated.

If a startup fails to raise a priced equity round before the convertible note’s maturity date, the note becomes due and payable. However, struggling startups rarely have funds to repay principal and accrued interest. This often leads to a “maturity default,” where the company is unable to fulfill its debt obligation, shifting focus from potential equity conversion to creditor claims against any remaining assets.

Investor Rights and Prioritization in Liquidation

In a startup’s liquidation or dissolution, a hierarchy of payments dictates which stakeholders receive funds first from any available assets. Secured creditors, with claims on specific company assets (e.g., banks), typically hold the highest priority.

Unsecured creditors are next. Convertible note holders are generally categorized as unsecured creditors. Their claims rank below secured debt but above all equity holders. However, convertible notes can sometimes be subordinated to other unsecured debt, further pushing them down the repayment order.

Liquidation preference primarily applies to preferred equity holders, though this term more commonly applies to preferred equity rather than convertible note debt. Preferred stockholders often have contractual rights to receive a multiple of their investment back before common shareholders. For convertible note holders, recovery in a startup failure is often minimal or nonexistent, especially if assets are insufficient after secured creditors are paid. The conversion feature becomes irrelevant if the company liquidates before a qualified financing event.

Scenarios Affecting Convertible Note Outcomes

The specific path a failing startup takes significantly influences the outcome for convertible note holders.

Formal Bankruptcy Proceedings

Formal bankruptcy proceedings, such as Chapter 7 or Chapter 11, dictate a structured process for handling a company’s debts. In a Chapter 7 liquidation, a trustee sells off assets. Convertible note holders, as creditors, must file claims to assert their right to proceeds. Recovery depends on available assets after higher-priority claims are satisfied. Chapter 11, a reorganization bankruptcy, is less common for early-stage startups due to its complexity and cost, but would involve a plan for debt repayment or restructuring.

Asset Sales or Distressed Acquisitions

In asset sales or distressed acquisitions, a startup’s assets might be sold, or the company acquired for a low valuation. Proceeds are distributed according to the liquidation hierarchy. Convertible note holders receive payment only after secured creditors, and potentially other unsecured creditors, have been paid. If sale proceeds are minimal, note holders may receive only a fraction of their investment, or nothing.

Informal Dissolution or Wind-Down

Informal dissolution occurs when a startup ceases operations without formal bankruptcy. Remaining cash or assets are typically distributed by management. This informal process generally follows the creditor hierarchy, with convertible note holders having a claim as unsecured debt. However, lack of court oversight can make the process less transparent, often resulting in no recovery if assets are depleted.

Implications for Founders and Noteholders

Startup failure with outstanding convertible notes has distinct implications for founders and noteholders.

For Founders

Founders are generally protected from personal liability for corporate debt if the company is structured as an LLC or corporation. However, personal liability can arise if founders provided personal guarantees on the notes or other company debts. Such guarantees obligate the founder to repay the debt from personal assets if the business defaults. Founders might also face liability for breaches of fiduciary duty during insolvency, such as misusing company funds.

For Noteholders

The primary consequence for noteholders is the loss of invested principal and accrued interest. While the financial loss can be substantial, tax implications may offer some relief. The loss on a failed convertible note investment can often be treated as a capital loss for tax purposes. If held for less than one year, it’s a short-term capital loss; if held for more than one year, it’s a long-term capital loss.

Capital losses can offset capital gains and, for individuals, up to an additional $3,000 of ordinary income per year. Unused capital loss can typically be carried forward to future tax years indefinitely. To claim this loss, investors need proper documentation, such as the convertible note agreement, to substantiate the loss to the Internal Revenue Service. A convertible note is not considered stock for certain tax benefits like Section 1202 Qualified Small Business Stock exclusion or Section 1244 ordinary loss treatment, as these apply only to equity.