DURHAM – In a year where North Carolina based companies raised over $1.1 billion, over 224 deals, 3 percent of the funding raised came in the form of a convertible note according to the Council for Entrepreneurial Development latest Innovator’s Report. The phenomenon is noteworthy because convertible notes are notoriously hard to track and until recently were uncommon.

A company will file a Form D with the Security and Exchange Commission when it closes a convertible note, however, it’s not required to disclose the source or that it is indeed a convertible note. To determine whether the Form D indicates a convertible note was executed, Jay Bigelow, CED’s Director of Entrepreneurship says, “you either have to know the company and know that’s what they did or use your best judgement.”

Until recently, convertible notes were an uncommon funding mechanism for early stage startups. Instead, they were made—typically by an inside investor—to “bridge” a scaling startup from one funding event to another. Bigelow says the rise of the use of convertible notes corresponds with the rise of accelerator and incubators because they began using convertible notes to float their graduates until the companies could raise an initial institutional investment round.

Beginning in 2016, CED began noticing a trend in their data: The use of convertible notes of all sizes to fund companies in all stages was rising. They doubled down on tracking the notes and by the end of 2017 saw a dramatic rise in their use in North Carolina’s startup ecosystem.

In 2016, 20 convertible notes accounted for $16 million or 1.9 percent of the $806 million raised. While 34 companies raised $35.95 million across 43 convertible notes in 2017 nearly doubling in the percentage of total funding they account for. The deals are all sizes too—one note reached $5 million.

To learn more about the trend, we caught up with Bigelow, and a local entrepreneur and investor who participated in a convertible note in October 2017— Monica Wood of Myxx and Tim McLoughlin of Cofounders Capital.

What’s Behind the Rise?

Some entrepreneurs continue to use convertible notes in the traditional way—as a bridge between two funding events or as a bridge to a new inflection point. Others are signing convertible notes as their first round of capital in lieu of a traditional angel investment or friends and family round. Still others are using them to raise large rounds of funding, like the aforementioned $5 million raise.

Tim McLoughlin

McLoughlin says his and his partner David Gardner’s philosophy on convertible notes is that the notes are useful for funding early stage startups who can’t yet demonstrate value or for a startup with previous investment that can’t quantify their progress for the next valuation. Cofounders utilizes them strictly for the latter reason.

While Cofounder’s will execute convertible notes with companies they’ve already invested in, McLoughlin says a convertible note will never be their first investment in a company. While they do issue convertible notes for about half of their companies, they only do so after they’ve already invested in them—typically as the first institutional investor—and with the sole intention of enabling the company to reach the next inflection point.

McLoughlin says Cofounders typically participates in the next price round too.

Monica Wood

Myxx raised a $400k seed round in October 2016 led by Cofounders Capital. Wood says the initial funding allowed her to hire a full-time team and develop her omni-channel marketing platform for brands and grocery stores. After the initial funding, Wood said they were ready to grow, needed more capital to stay ahead of the competition, but couldn’t define, “what we were worth at that moment.”

And McLoughlin says, “we wanted them to be able to fuel their growth, to keep doing what they’re doing,” so they could reach a place where they could define Myxx’s value for a price round. So, Cofounders and Myxx mutually agreed a convertible note was the best funding option for the moment and executed the note in October 2017.

A screenshot from Myxx

Wood says the note “helped us accelerate and stay ahead of the market that we’re in.” Myxx plans to raise a Series A in the fall of this year, and McLoughlin says Cofounders will “be pleased to participate and identify value added strategic investors to come alongside us in that round.”

Does the Trend Say Anything About the Triangle?

Bigelow doesn’t believe the funding environment has impacted the rise of the use of convertible notes. He says, “if you’re an early stage company, finding funding is hard, but it’s always been.” Instead he says signing convertible notes has become “fashionable” to a degree because of the ease and speed at which the notes can be executed. Because they’re a debt instrument, convertible notes can be negotiated without the covenants and governance conditions found in traditional equity deals. But there’s a catch—the investor can set a discount on their future equity purchase price or a cap on how much of the note can convert into equity. Bigelow says the caps “somewhat pre-negotiate what the next round looks like.”

Even so, Bigelow isn’t concerned about the rise in use of convertible notes as a fundraising instrument. Nor does he think it signals anything specific about the market or ecosystem. Instead he calls it “interesting” but believes it is worth tracking.

McLoughlin posits the rise is due to a discomfort in the region to pricing and valuing a company. He says, “there’s a reliance on outside groups to come in and be the lead” and value a company’s worth. In a convertible note, a lead investor—and thus a party who is willing to value the company—is not required. McLoughlin thinks this explains their popularity.

While Bigelow won’t speak to the strategy’s efficacy, he does believe entrepreneurs should view funding as a “series of stepping stones” and strategically plan each step from the beginning, just like they would a go-to-market plan or IP strategy. He says, “they can be great for the entrepreneur, as long as the decision to take part in a convertible note is part of a strategic funding strategy.”