Every business, organization, and startup requires funding to transform its ideas into reality or to scale its business. Companies typically rely on some form of external funding to sustain its growth. Equity financing, debt financing, and mezzanine financing are the three major financing models for businesses and corporations. Equity financing involves the allotment of shares to investors willing to inject capital into a company. Debt financing involves raising money in the form of loans from banks and other financial institutions. This model is made on the terms that security (collateral) will be provided by the entity seeking funds and that such funds raised will be repaid (together with accrued interests) over an agreed period of time, irrespective of whether or not the business makes a fortune. Mezzanine financing is a hybrid of both debt and equity financing. Mezzanine funding could refer to the injection of part cash in exchange for equity and part debt in exchange for interest payments.
A convertible note combines debt and equity financing. It is used by early-stage startup investors and is a short-term debt that converts into equity. Convertible notes are structured as loans with the intention of converting them to equity. The investor would be loaning money to a startup and instead of getting a return in the form of principal plus interest, as is the case with typical loans; the investor would instead receive equity in the company. These investors assume the role of a traditional bondholder. Different types of equity are available to various stakeholders within a startup; common shares and preferred shares. More often than not, the investor gets preferred stock in the startup. Early-stage startups sometimes will raise money via convertible securities if they’re not ready to firmly establish their valuation, or are between rounds of funding, and need to raise money relatively quickly. Therefore, the investors use convertible securities/notes to essentially buy time until a priced equity round occurs, which will inform how the investment amount translates into shares in the company.
What are the key components of a convertible note?
a. Conversion/Discount Rate: Investors are generally given an additional discount on the price of the shares, compensating them for the risk they took by investing during the early phase of the startup. The conversion discount essentially allows the investor to buy more shares with their investment fund than later investors.
b. Interest Rate: Rather than compensating the investor in cash for the interest that accrued on the investment, the interest of a convertible note would increase the number of shares that are issued when the note converts into equity. Interest rates for convertible notes are usually low.
c. Type of Equity Interest: Different types of equity are available to various stakeholders within a startup; common shares and preferred shares. The debt typically converts into shares of preferred stock based on the terms of the note.
d. Maturity Date : As with other forms of debt, convertible notes have a maturity date at which the investor can request a full payment back from the company. This is the date at which the debt or fund advanced by the investor becomes due and payable (with interest), if the note is not yet converted to equity. If the startup has not converted the note into equity by the maturity date, the investor can extend the date that the note will mature or call for an actual repayment. The maturity date is also a time limit on the company to achieve the growth or potential necessitating the next round of financing while protecting the investor from an endless possibility of not seeing a return on investment.
e. Valuation Cap: The valuation cap is the most important term in a convertible note. It is a way to reward seed stage investors for taking on additional risk. A key consideration for any startup is what any amount raised under a convertible note will convert into at the next round. The valuation cap sets the maximum price that your convertible security will convert into equity. A very low valuation cap could result in a toxic cap situation, and may even deter the next round investors.
When should convertible notes be used?
Convertible notes are preferable to startups because they are quicker, easier, and cheaper to issue than equity. Speed, simplicity and cost are factors that influence a startup’s use of convertible notes. Although, the issuance of preferred stock is complex and could take weeks for negotiation of terms and documentation. The reason most investors would want a convertible note is if such startup has a strong growth trajectory. Convertible notes are ideal for early-stage startups that are in high-growth phases. Convertible notes are also used to give founders more time to determine a valuation for their company. The valuation determines what percent of the company is being offered. Sometimes, it could be difficult to know exactly how much a startup will be worth, especially in its early stages and as such, Convertible notes allow issuers to defer valuation negotiations until a subsequent round of financing. This affords the company time to develop metrics that can be used to determine a fair price in subsequent rounds of funding
Convertibles notes are a great way for founders to raise funds easily, no doubt. They must however take into consideration the key features of a convertible note to avoid falling into pitfalls.