One can say that it is a good time to be an entrepreneur, mainly because we are living in the golden age of seed financing. Venture capital funds, super angels, angel groups, incubators and even friends and family are all chipping in and playing the seed financing game by investing in an attempt to land the next big money maker. Over the past decade, convertible debt (also known as convertible note) has emerged as a quick way for startups to raise money, which were basically bootstrapping it thus far.

Often used by angel investors to fund businesses without establishing an explicit valuation of the company in which they are investing, convertible notes seem to be all the rage for pre-revenue startup businesses these days. Here’s the what, why and how of a convertible note:

What is a Convertible Note?

It is often difficult to assign a valuation to startups. If you are an entrepreneur and are in need of funding, one of the questions that you need to address is how much your company is worth. However for pre-revenue startups, this is a very tough cookie to crack. This is where issuing a convertible note comes in handy.

A convertible note is short-term debt that converts into equity. The outstanding balance of the loan is automatically converted to equity when a later equity investor appears. It combines the features of bonds and stocks into one instrument. It gives the holder the right to convert or exchange the par amount of the bond for common shares at some fixed ratio during a holding period.

With a convertible note, an entrepreneur is essentially saying- I need money but I don’t know how much my company is worth. How about you give me a loan and I repay the loan with interest at end of term. To sweeten the deal, I will give you an option where you may choose to not collect your loan amount, and instead convert it to equity when I am raising my next equity round. You will be compensated for this loan amount by getting a discounted valuation as compared to other investors.

How does it work?

So, what is the rationale behind the convertible note? Investors loan money to a startup as its first round of funding and then rather than get their money back with interest, the investors have an option to receive shares of that company, that are based on the terms agreed upon initially.

Conversion discount:

A conversion discount is a mechanism that rewards the note holders for their investment risk, by granting to them the right to convert the amount of the loan, at a reduced price that was paid for the purchase by the new equity investors.

Valuation cap:

A conversion valuation cap is another mechanism that has been put in place to reward the convertible note holders for their investment risk. A ceiling is put on the value of the startup for purposes of determining the conversion price of the note. Just like a discount, the conversion valuation cap permits investors to convert their loan, at a lower price than the purchase price paid by the new equity investors.

Funding Options for Startups

Give me an example

Assume that Steve is interested in investing $40,000 in a startup via a convertible note. The agreement states that Steve can get his investment back with a 6% interest after two years or he may choose to participate in the next financing round to convert his $40,000 into equity shares. Should he choose to do so, he would be entitled to a 20% valuation discount or get to participate at a $4MM valuation for the company, whichever is lower.

Discount:

Assume that the next round is valued at $3MM. In that case, Steve gets to convert his investment into equity at a 0.8*3 = $2.4MM valuation. So his $40,000 investment gets him 40,000/2,400,000= 1.67% equity stake, as opposed to the 1.33% stake that others investing $40,000 get at a $3MM valuation.

Valuation cap:

However if the company’s valuation is $5MM at the next round, then Steve has the advantage of still being able to convert his $40,000 investment at a $4MM company

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valuation, thanks to the valuation cap in his agreement. This means he gets a 1% equity stake as opposed to 0.8% equity that others investing a similar amount get in this financing round.

Pros and cons of investing in a convertible note:

  • Convertible notes are a favorite amongst investors because they enjoy more protection than the equity holder in the event that the company is forced to wind up or dissolve while also getting the rights to participate in the company’s future offerings at a discounted price.
  • Nine times out of ten, a first-time entrepreneur will not achieve the operating objectives on a timely basis. Most startups go bust before they can raise a future funding round.

Filling the startup funding gap:

There is a clear trend emerging of finance by way of a convertible loan note. This type of fundraising is limited in its amount and won’t replace large equity raising for large businesses. At the moment, straight equity deals are hard to come by but convertible notes are very popular.

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