Toptal, a company that matches businesses with software engineers, seemed to have all the markers of a Silicon Valley unicorn. The company was founded by two young entrepreneurs in 2010, raised money from well-known investors like Andreessen Horowitz, and hired talented employees who were promised equity that would make them very wealthy if the company did well.
And, on the surface, things did go well. Toptal quickly became profitable, bringing in over $200 million in annual revenue and growing 40% year-over-year (according to LinkedIn). They were achieving the kind of success few startups survive long enough to see and that should bring astronomical returns for early investors and employees.
Except, it hasn’t.
Toptal, which is rumored to be valued at more than $1 billion, is still 100% owned by its Chief Executive Officer (CEO), Taso Du Val. Toptal’s investors, early employees, and even Breanden Beneschot, Toptal’s co-founder, were all promised equity if the Company raised additional funding — but that hasn’t happened despite the Company being in operation for 13 years.
And while Du Val’s actions are certainly not the norm, they are completely legal.
Toptal: Unintended Consequences of Convertible Notes
In 2012, Toptal raised $1.4 million from Andreessen Horowitz, Quora CEO Adam D’Angelo, early Facebook employee Lucas Nealan, and others using convertible notes, which is a type of convertible debt instrument that converts into equity at a later date (typically upon a maturity date or financing round, whichever happens first).
According to The Information, Toptal’s convertible notes had a valuation cap of $10 million or $11 million, depending on the investor. This meant that if Toptal completed a future equity financing round at a higher valuation, the investors’ convertible notes would convert as if Toptal’s valuation was $10 million or $11 million (depending on the investor). Valuation caps are typically included in convertible notes as they allow investors to lock in the price of their future equity and can result in a huge discount to those investors if the company’s valuation is significantly higher at the next equity financing round. Companies often use valuation caps as an added incentive for investors that write early checks and therefore take more of a risk given the early stage of the company.
But Toptal never raised additional capital and we assume there was no maturity date by which Toptal had to either raise another equity financing round or convert investors’ convertible notes into equity.
This created a loophole for Du Val and meant that under the terms of the convertible notes, contractually he doesn’t owe anyone equity so the convertible notes remain outstanding.
Convertible notes are debt instruments designed to be a quick infusion of capital for founders either before they raise a priced round or in between priced rounds. They are often referred to as “bridge rounds”. They are different from the other popular form of capital infusion, Simple Agreements for Future Equity (SAFEs) because they have an interest rate and maturity date (i.e., the date by which convertible note must either be repaid or converted into equity). However, investors aren’t interested in the small interest that they receive while the convertible note is outstanding. Instead, they agree to convertible notes because they convert into equity in the company and, ideally, at some point in the future that equity stake will be worth 100x their initial investment amount. But as the Toptal situation demonstrates, the inherent risk of these convertible instruments is that a subsequent equity financing round is required for them to convert into equity. Without a conversion, the convertible notes are simply a promise, not a guarantee, of equity.
According to Du Val, the reason for the convertible notes remaining outstanding is simple: the Company doesn’t need to raise additional capital. This means Toptal’s early investors and employees hold outstanding convertible notes that haven't been converted into equity. For context, if Andreessen Horowitz’s convertible note had converted into equity, its stake in the company would be worth over $250 million today.
We suspect that according to the terms of the convertible notes, Du Val hasn’t done anything wrong, but as an investor told The Information, “Silicon Valley runs on the trust that people aren’t going to do something like this.” Meaning when you invest in a company on a convertible note, you expect it to convert into equity in a reasonable time period.
It’s important to remember that the unwritten rules of Silicon Valley only work when everybody abides by it. As an investor, it’s important you protect yourself in the event that you come across someone who doesn’t. There are two clauses you can use to protect yourself, which we’ll explain below, But first, let’s explore convertible debt instruments through the lens of another Silicon Valley Unicorn.
Notion: An Alternative Tale
For companies that reach profitability before raising a priced round, there’s a friendlier route. This route was taken by Notion, another Silicon Valley success story.
Although investors were fiercely trying to invest in Notion, the company – just like Toptal – didn’t need more money. However, unlike Toptal, it is alleged that Notion chose to raise a small financing round to convert its existing investors’ convertible notes into equity so that they were not left with an indefinite promise of future equity in the company.
Notion played by the unspoken rules of Silicon Valley, while Toptal did not.
By taking this route, Notion was able to reward its early investors and employees by giving them an ownership stake in the company, while avoiding the dilution that comes with raising a large equity financing round.
Protect Your Equity: How to Draft Your Convertible Notes
While the unwritten rules of Silicon Valley work most of the time, when they don’t, they can have catastrophic consequences for the investors and founders that rely on them. If you’ve learned anything from the Toptal example, it’s that you need to understand what’s in the documents you’re signing and make sure that your documents account for various exit strategies (including when a founder doesn’t raise additional capital).
In the Toptal example, the early investors and employees certainly wish they had a maturity date provision in their convertible notes that would force the Company to convert the convertible note into equity upon the maturity date even if a financing has not occurred.
Additionally, investors can add language to make sure that any additional equity financing round triggers the conversion of the convertible notes.
The moral of the story is clear: make sure your convertible notes either (i) automatically convert into equity upon a maturity date or (ii) do not have a minimum financing threshold for conversion such that any additional capital raised will convert your convertible note into equity.
If you’d like to generate your own convertible notes, check out Cooley Go’s Convertible Note Generator.
A special thank you to our co-author Annia Mirza!