Entrepreneurs can choose from a few basic structures when sourcing capital for a new business venture via equity crowdfunding – debt, revenue share, equity, and convertible notes. With equity crowdfunding, an entrepreneur is not required to repay the funds over a defined period, but his or her stake in the company gets diluted through the issuance of equity, or stock in the company, to multiple investors. As for debt, an entrepreneur is required to pay the interest throughout the loan term with the principal repaid at maturity.
Investors today often resort to using a financing option, which is called convertible debt. Convertible debt (usually in the form of a convertible note) is a funding mechanism that combines the benefits of equity investment and debt into one capital source. Essentially, it is a loan that converts to equity at a pre-set date.
What is a Convertible Note?
A short-term loan with maturities from 12 to 36 months is called a convertible note. Paying interest in cash would quickly deplete the resources of a startup, so instead of that, the interest accrues until conversion or maturity. The conversion of a loan into equity is triggered by a Series A financing round (a subsequent equity financing round following the seed round). Most convertible notes have a conversion price lower than the price of the subsequent financing round through the use of a discount on the purchase price or valuation cap. This lower conversion price compensates convertible note holders for the risk related to investing during early funding rounds.
The risk of investing in early-stage businesses is higher, but so are the rewards. However, there’s no assurance of whether a convertible note holder will realize a return on his or her equity investment or if they will lose the entire investment. Unless there is a future IPO (Initial Public Offering), fundraising event, or sale of the company (none of which can be guaranteed), convertible note holders will not become equity holders.
How to Evaluate a Convertible Note?
The main advantage of issuing convertible notes is that it doesn’t force the investors and company to determine the value of the company prematurely. In the early stage of a business, there is not much information to base a valuation on, and the valuation is typically determined during the Series A financing. Every investor should keep in mind a few key parameters when evaluating a convertible note.
- Interest rate. As an investor, you are lending money to a company, and convertible notes will often accrue interest. However, instead of being paid back in cash, the interest will keep accruing to the principal amount you’ve chosen to invest in convertible notes, increasing the number of shares issued after conversion.
- Maturity date. The maturity date is the specific day on which the convertible note is due and the company is required to pay back the early seed investors. Upon expiration, maturity dates have to be renegotiated.
- Valuation cap. When investing in an early-stage company, the risk is much higher. The valuation cap is one of the additional rewards for bearing that risk as it caps the price at which your convertible notes convert into equity. It limits the maximum price set for the conversion of a convertible note, allowing investors to benefit in the upside of their investment (like they would have in a regular equity investment).
- Discount rate. This is another additional benefit of taking a risk by investing in a startup. It’s the discount on the Series A valuation (which is when the convertible note gets converted to equity). The typical discount is 20%, so if the Series A fundraise is $1 million, you would get your equity at $800,000 (as an early investor).
How Convertible Debt Works in Equity Crowdfunding?
Being a debt instrument that gives stock options to investors, convertible debt holders get security from the downside and more potential upside (if the startup is successful). Convertible debts are much faster than equity rounds because there are just two documents in place – the convertible note purchase agreement and the promissory note (which outlines the amount the investor is putting in and the conversion).
Let’s take a look at how convertible notes work for an equity crowdfunded startup and how they convert to equity by seeing how the discount rate and valuation cap interact in this financing structure. For example, imagine an early-stage company that issued a convertible note with a 20% discount and a $4 million valuation cap in order to raise its seed round. If the startup is raising money at a $10 price per share and a $12 million pre-money valuation, the value of a share will convert to $8.
However, the valuation cap would result in $3.33 per share, the price at which the convertible note holder would convert into Series A shares. In this case, the valuation cap is driving the conversion. In another scenario, the startup is raising its subsequent funding round at the same $10 price per share and only a $4.5 million pre-money valuation. The price of a share would again be $8 in this funding round, due to the 20% discount. However, after dividing the valuation cap by the pre-money valuation and applying it, the price per share would result in an $8.89 per share for investors in this funding round. In this case, the conversion is driven by the discount. Note that for simplicity in the explanation, we ignored the accrued interest in the previous calculations.
The maturity date is what companies always keep a close eye on because it’s the date by which they agree to repay their investors if they haven’t done a round of financing in which convertible notes turned into equity. They need to be convinced that they’ll be able to raise a qualified round of financing before or on that date to avoid being in default.
The Bottom Line
Convertible debt (note) is probably the cheapest and fastest way to raise capital without having to negotiate too many details with the investors. However, the conversion is what can be complicated because fixed terms, interest rates, and taxes represent different things across different states. That’s why it is important for company founders to understand how venture financing and other available funding alternatives work.
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About: Chris Lustrino
A Boston College Eagle for life, on a mission to democratize startup investing for all people at KingsCrowd, with a passion for Fintech, investing, social impact, doing well and doing good, and an avid runner, cyclist and writer.