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What are convertible notes (and why investors love them)

What are convertible notes (and why investors love them)

When you are looking to raise capital, a lot of options are available with a lot of strings attached:

  • Bootstrapping
  • Credit Cards
  • Friends and Family
  • Equity Financing
  • Bank Loans
  • Larceny (not recommended)
  • Crowd fundraising

For a budding entrepreneur it all can be quite overwhelming. Even for seasoned and serial entrepreneurs, usually it falls to the market conditions to determine whether there is capital available for procurement.

However, a common practice is the use of convertible notes. Convertible notes are a fast, short-term, form of debt that converts to equity.  Very often, seed and pre-series A rounds incorporate convertible notes, yet entrepreneurs are not always aware of all the conditions involved.

Let’s dive into this enigmatic topic and see the underlying values associated with convertible notes.

What are convertible notes?

 

A convertible note is a form of debt financing that is turned (converted) to equity after a subsequent capital financing (that involves issuing shares).

Debt is often typically viewed as being cheaper than equity – ‘legacy’ debt (bank debt) is an immediate source of cash which can be repaid through monthly installments.  This avoids the issue surrounding company valuation.

Company valuation is often difficult at this early stage of financing as there are usually relatively few metrics available to justify any accurate representation of the company. Hypothetically, if you were to value your company too cheaply, you may be giving away ownership groundlessly (and grossly misrepresenting your worth). On the other hand, too high of a valuation could lead to investors questioning your industry knowledge and could put unnecessary pressure on your company to perform more quickly than it should. A convertible note marries both debt and equity into a relatively quick means of finance. The primary advantage for you to issue a convertible note allows you to defer your company’s valuation until a later round (typically Series A) where you expect to raise a larger sum of capital.

As you know, in investing you often need to have a high level of risk tolerance. The skeleton of a convertible note directly benefits aggressive investors who are willing to invest in early stage companies with little industry exposure or metrics.

 

4 main parameters in a convertible note:

Discount Rate:

This highlights the valuation discount that the investor (who owns the note) will receive in subsequent financing rounds relative to other investors in the round. This discount helps indemnify the early stage investors in the long-term. For example, if you offer a 20% discount through your convertible note, and your shares in a subsequent round are valued at $1/share, then your note will convert into equity with 20% discount on the $1/share, meaning each share is now only $0.80/share. This means that the investor who owns the convertible note will receive 25% more shares for the same amount of cash compared to an investor who does not have a convertible note.

Interest Rate:

Traditionally like all forms of debt, convertible notes accrue interest, however untraditionally this interest is paid in additional shares on conversion. For example, if you issue a convertible note of $50,000 with a 5% interest rate, during a financing event in 1 year’s time, the note would have accrued $2,500 in interest and thus the investor would be entitled to $52,500 worth of shares at the appropriate conversion rate.

Maturity Date:

This is the date at which the convertible note is due for repayment. If a company has not been financed by then, the startup is obliged to repay the convertible note as a typical debt repayments rather than it being converted to equity. 

Valuation Cap:

This is another additional compensation for being an early stage investor. This is where you preempt the valuation of a subsequent financing round to benefit the investor. In turn, the subsequent valuation is ‘capped’ at this value for this investor and they receive shares as if the valuation was this price, rather than at a higher valuation. For example, if an investor has a valuation cap of $5M and the company is actually valued at $10M come the Series A financing, the investor will convert into equity as if the valuation was actually 5M dollars. This means the investor will receive double the number of shares compared to another investor who invests the same amount of cash but who does not have a convertible note.

 

 

As you may notice, there are two separate scenarios for convertible notes that benefit the investor – converting at the discount rate or converting at the valuation cap. This is an important point as the note converts at whichever scenario gives the investor a better price (more shares per $, or higher equity). Thus, either way, investors receive the best return when it comes to convertible notes.

 

Example

The Cawfee Company, a millennial-founded fair-trade coffee roaster and distributor, is looking to purchase new equipment to handle the recent boom in business. Due to time constraints and how early the company is, they decide a convertible note is the best plan of action. The Cawfee Company issues a convertible note to Cocoa Capital with a $5M valuation cap with a 25% discount.

A year later, the Cawfee Company decides to hold a financing round.

The pre-money valuation is $10M with a $4 price per share. The 25% discount applies and Cocoa Capital will be able to purchase shares for $3/share rather than $4/share.

On the other hand, with the $5M valuation cap, Cocoa can purchase shares as if Cawfee were valued only at $5M, thus the adjusted value is obtained by the following formula:

\frac{\mbox{Valuation Cap}}{\mbox{True Round Valuation}}* \mbox{Price per share}

Here this is
\frac{5\mbox{M}}{10\mbox{M}} * \$4/\mbox{share}

Thus Cocoa would be able to purchase shares for $2/share.

 

Since $2/share is more ‘bang-for-their-buck’ compared to $3/share, Cocoa will convert at $2/share.

The $1 difference, in this case, equates to the potential to buy 50% more shares.

Conclusion

Overall convertible notes offer a rapid way of generating cash , often exactly what your startup may need. However, you must also consider some consequences of using convertible debt as a means of financing. Sometimes, convertible debt may be damaging to the company if it does not succeed – the debt is a debt and thus must be paid. If your company is struggling to raise cash and the maturity date is reached, the debt must be paid – potentially forcing a liquidity event if the firm is not cash-buoyant enough. Convertible notes have their pros and their cons, and it’s up to you, as an entrepreneur, to understand the risks and rewards with their convenience.

 

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