Startup financing is complicated, especially in the very early stage. To help the startups raise seed money, convertible notes were introduced.
What are convertible notes?
Convertible notes are basically short-term debt instruments which convert to equity after a specified period. However, the amount of equity of the firm to be received by the seed investor is only decided when the term is over, and for that period, these notes act purely as a debt instrument. Usually, the conversion is done during the Series A funding round when the company is valued by the venture capitals.
Why are convertible notes used?
In the nascent startup stage, it is challenging to make a valuation of the company mostly due to the lack of data and a hefty fee charged by the legal consultants. So to ease the early-stage fundraising process on the part of both the seed investor and the startup, convertible notes are used.
Bill Clark, CEO of MicroAngel Capital Partners, wrote at Mashable: “Determining the valuation of a startup is hard, especially if the startup is pre-revenue and only in the idea phase. How do you put a value on the potential of the team/idea? It is easier for a startup to put off that question until they have some traction and social proof. Convertible notes are attractive for a startup because it delays this issue. While adding a cap essentially prices the round, it does leave a range of options, so it is more attractive to the startup.”
“The equity valuation conversation can take weeks of negotiating before terms are agreed upon. With debt, the terms are simple, easier to negotiate, and you can close on them pretty quickly,” Clark added.
Convertible notes use a few parameters to calculate the rate at which the investment amount will be converted to equity. The primary conversion parameters are discount rate and valuation cap.
As the investor takes a significant risk by investing in the early stage of the startup, a discount in the valuation is provided to him/her relative to the investors participating in the subsequent rounds.
To further reward the seed investor, the startup sets a valuation cap. It defines the maximum price at which the convertible notes can be converted into preferred shares. It further benefits the investor by allocating the equity at a higher discount rate, if applicable, based on the performance of the startup in between seed and Series A funding round.
Out of the two, the conversion rate is decided on the parameter which gives the investor a higher value upon the end of the term.
Though the investor ultimately receives equity against the seed investment, convertible notes are, by nature, a debt-instrument. So to define the terms of the debt period, two more parameters come handy – interest rate and maturity date.
Before converting to equity, convertible notes provide interest to the investor on the invested amount, considering its debt-instrument nature. The interest rate defines the interest the investor will receive on the invested principal amount till maturity. However, unlike traditional debt-instrument, the startup does not pay up the investor in cash, but interest adds up to the principle and increases the amount of equity the investor is about to receive on conversion.
Debt instruments come with a maturity date, and so do convertible notes. The maturity date denotes the agreed upon due date of the instrument after which the startup is liable to repay the principal amount along with the incurred interest to the investor.
Example of a convertible note
Let’s consider a company which raises seed money using convertible notes with a $5 million valuation cap and 20 percent discount rate. Now, if the price for the next round is set at $5 million, the notes will convert as though they are originally priced at $4 million (considering the discount rate). However, if the next round is priced at $10 million, the notes will convert at a $5 million price instead of $8 million, as $5 million was the cap of the price of the original equity.
Moreover, let’s say an investor invests $1,000 in the company and the interest rate is set at 10 percent with a maturity of 5 years. Now at maturity, the convertible amount against which the investor will receive the equity will be $1,500, an amount which includes the principal plus the interest for the time.
Cons of convertible notes
Convertible notes, like every other financing instrument, is not perfect and raising seed funds using them has quite a few disadvantages, most of which are on the part of investors.
By investing through the convertible notes, the investors take a substantial risk. New investors often face problems while negotiating the terms of the notes. Moreover, at the time of valuation, disputes often arise between convertible note holders and the future investors, who usually take charge of the process. Also, in case of uncapped notes, conflict of interest may arise as the issuer benefits from a higher valuation of the firm while the opposite is true for the investor.
In case of the startup, if the investor holding convertible notes, does not convert it will eventually come due. This might create financial pressure on the entrepreneurs and often lead to a shutdown.
Andrew Krowne, a principal at Levensohn Venture Partners and Dolby Family Ventures, wrote in an article published by TechCrunch:
“While there are proper uses of notes (to bridge the company to achieve a major milestone, or driven by insiders’ willingness to extend runway), there also are troubling and frequent improper uses (to postpone pricing equity until valuation is higher or to ignore the implicit message associated with being unable to find a lead investor to price the round on terms that the founders like).”
“At its core, this issue points to the lack of understanding about the importance of post-money valuation by both entrepreneurs and investors. While VC deals remain marketed on a pre-money basis, sophisticated investors know that what matters most is the post-money (how much of the company will I own after all of the new shares have been issued). Unfortunately, what the CEO/founder forgets most often is that the notes have a multiplier effect in the post-money calculation; the more notes and the further the cap is from the new priced equity, the greater the variance between actual and nominal pre- and post-money valuations,” he added.
Conclusion: To issue or not to issue?
Well, there is no doubt that convertible note makes the seed fundraising process very easy and its simplicity has attracted many entrepreneurs to raise early funds with it in last decade. However, due to the associated risks, both startups and investors should consider the prospects as it is only one financing option, among many.