July 12th, 2022 | By: The Startups Team | Tags: Funding
Continuing in Phase One of a four-part Funding Series:
Phase One - Structuring a Fundraise
Part 1 - Startup Bootstrapping
Part 2 - Debt as Startup Capital
Part 3 - Equity Funding for Startups
Part 4 - Convertible Debt ( ←YOU ARE HERE 😀)
Phase Two - Investor Selection
Phase Three - The Pitch
Phase Four - Investor Outreach
Let's dive in!
Convertible Debt (or a “Convertible Note”) is often used as a method for making an equity financing investment. Unlike regular equity financing investments, though, Convertible Debt includes terms like an Interest Rate, Maturity Date, and Valuation Cap - which we’ll explain here as to how they play a role in a Convertible note.
Convertible Debt is essentially a mash-up of debt financing and equity financing: you borrow money from investors with the understanding that the Convertible Note will either be repaid or turned into a share in the company at some later point in time. This conversion happens after an additional round of fundraising, for instance, or once the business reaches a certain valuation or share price.
Key Takeaway: Convertible Debt is a “loan” that converts into an equity investment at some future date at or below a specific Valuation Cap. It’s a very popular way for early-stage startups to raise money versus a traditional equity funding round.
The goal is for convertible note holders to invest capital into an early-stage startup company now without having to worry about what the exact valuation might be just yet. The convertible note structure essentially “punts” the valuation until a later funding round, which is typically when venture capital funding steps in.
Convertible Notes are a “loan” made to startups at the very early stages that is intended to be short term debt which will convert (with interest accrued) into equity based on the next qualified financing round (often from Venture Capitalists).
The Convertible Note is invested as a loan initially, with the understanding that the loan will convert to an equity investment when a specific trigger event happens. The trigger event is typically the next round of invested capital(like a venture capital round) where the value of the company is better known. Typically the interest that accrues on the loan is simply added to the investment amount at the time of conversion instead of being repaid periodically like a traditional loan.
Jenny Angel Investor wants to invest $100,000 into Mary’s startup. Since the venture is new, both agree that they will issue the $100k as a convertible note, and wait for a future round to determine the valuation of the company. When Mary raises her next larger round of financing, the company is valued at $1,000,000. Joe Angel then converts his $100k of invested capital into an investment in Mary’s startup at that point and becomes part of the Cap Table.
Convertible Notes have actually become the standard method of early-stage fundraising because convertible note alternatives have really sped up the ability for angels investors to start investing earlier. Prior to this, a startup with rapid growth potential could easily be stalled with investors arguing over a post money valuation that realistically no one can set.
That’s why most startups and investors have moved to convertible notes which are faster to execute, cheaper in legal fees, and well understood by both angel investors and venture capitalists. Wins all around!
Convertible Notes differ somewhat from typical Equity Funding in that the convertible note debt really doesn’t exist in a regular “priced round”. By comparison, a Priced Round, where equity holders simply get a percentage of the company upon investment, a convertible note holder actually doesn’t know what percentage of the Cap Table they will receive.
That happens upon the equity “conversion event”, which is typically when the next “priced round” takes place. Again, this tends to happen later on when new, larger equity holders invest. With a price round there is no convertible note element at all, so there’s no short term debt (or interest rate, maturity date or valuation cap) to worry about.
A Convertible Note makes the most sense for startups that are not yet ready to set a valuation for their company, either because it’s too early to determine one, or because they have reason to believe that the valuation will be much higher at a later date. Frankly, that’s almost always the case for early-stage startups and why they all default to convertible notes.
Convertible Notes tend to favor the startup company versus the note holders because it provides a mechanism where the entrepreneur can give up less future equity, especially if the company winds up becoming wildly successful. There are some safeguards in place for investors in convertible debt, including a Valuation Cap which determines the maximum share price investors will pay upon conversion (we’ll cover that more as we go).
Most early-stage companies are almost impossible to value by seed investors in their infancy. Is your mobile app pre-money valuation $250k, $2.5 million or $20 billion? (Answer: not $20 billion). In almost every case it’s too early to make that determination until the startup has had time to put the investment to work and create a product that has more tangible value.
The goal is then to let a later investor – who can more aptly determine the value of the company because it has matured enough to do so – to value the company. It’s a bit of a risk on both the startup and the investor’s part because the future valuation could favor either party a bit more. To protect against that (for the investor) there is something called a “valuation cap” that we will discuss later that limits how high the future valuation can affect the existing convertible debt investment.
Although convertible debt deals are typically intended to convert to equity at a future date, that conversion is almost always intended for a future financing round. Of course, there’s no guarantee that early-stage startups will raise more money, either because it can’t or it doesn’t need to.
In that event, the convertible note will simply turn into a traditional loan, at which point you really will have to pay that amount back unless you can agree on a fair valuation to convert the note to equity. What’s nice is that both parties have a bit of optionality to consider either outcome. Some startups who are on the fence about future funding will use convertible notes as a bit of a hedge between taking on equity versus some other debt investment.
Convertible Notes tend to use fairly standard legal documents to bring both parties together earlier. At this point the investing world has standardized on convertible note terms which makes most convertible notes very simple. Since there often aren’t as many provisions as an equity investment (because technically it’s not an equity holding – yet) the negotiations tend to move by a lot faster and therefore the raises tend to be more streamlined. There’s just less to argue about!
While convertible debt tends to favor the entrepreneur, the whole convertible note structure isn’t without its challenges.
Compared to a straight equity investment that has no repayment provision, convertible debt is by all means still a loan, so it’s important for Founders to know how a convertible note works in that regard. That means the investor may not choose to convert that money into equity and instead ask to be paid back – with interest - based on a specified Maturity Date.
Comparatively, a straight equity investment doesn’t get repaid (at least not like a bank loan). You have the peace of mind in knowing that whatever investment has been made is essentially “permanent” and can’t turn into some new liability further down the road. To be fair, this doesn’t happen that often because either the company can’t raise more money (no trigger event) and just goes out of business or it does well enough that the investor would prefer to convert to equity (forgiving the loan).
With convertible debt, you are punting the valuation to some future period down the road. Unfortunately, you’re also running the risk that when you do raise money, the valuation of the company could be lower than what you had anticipated in this round.
Investments work on a lot of speculation about the future. Sometimes the rosy picture of the future is even rosier when the concept is just a sexy idea and not a real company that has real challenges. The moment you take investment capital and find out that the product has shipped later than expected, customers didn’t pay like you thought they would, and your time to profit might be a much longer road than expected – that can all go south when it comes to valuation time.
By contrast, locking in a valuation now (and just doing a typical equity investment) can provide some potential downside risk if the valuation you’re getting now feels reasonable.
Generally speaking, investors prefer to negotiate a valuation now, so they don’t have to wonder if they may get a discount against their investment later. If you’re working with investors who aren’t particularly enthusiastic about the terms of convertible debt (not all are), you may run the risk of turning off prospective investors who would otherwise consider investing. Like anything else, this is simply a matter of having an open dialogue to discuss preferences.
Often, investors will say yes to convertible notes when they are the easiest way a deal can get done. It eliminates the need to debate valuations, which is hard in early stage companies, and often seen as a waste of time for investors and founders alike. In other cases, when there is a lot of demand for investment in a specific company from many investors, they'll agree to convertible notes just to get into the deal. FOMO for the win.
Convertible Debt deals are really just driven by a handful of specific terms that govern the events that trigger the debt (to convert) and the value of the existing investor’s capital when their debt converts to equity.
Most of these terms are fairly standard within Convertible Debt documents so if you’re having a discussion around setting up a convertible debt instrument, you’ll definitely need to know these terms:
Just like any loan, there is an interest rate and of course interest that accrues once the loan originates. It’s typically not payable until the loan is converted into equity.
A valuation cap sets the maximum valuation the convertible debt loan can be converted at. If an investor put in $100k with a “valuation cap” at $2,000,000, but the company raises more money at $5,000,000, her $100k will convert at the $2,000,000 valuation while the new investor will put money in at that $5,000,000 valuation. This is designed to incentivize early investors.
The discount rate gives convertible debt investors a “discount” to the future valuation so that their investment is worth more than later investors. A 20% discount rate (which is common) means that if the company gets a $$1,000,000 valuation in the future, their money converts at a $800,000 valuation (a 20% “discount”) which makes their $100k investment worth more.
The convertible debt “converts” into equity upon a “trigger event” which is a predefined event such as a future financing round. There can be a few trigger events in addition to a future financing round such as a future date (ex. 3 years from closing the convertible debt round) or the sale of the company.
Since Convertible Notes are still considered debt, they have Maturity Dates like any other loan. For most Convertible Notes investors will expect a 3-year window setup for maturity dates (these do vary) whereby the convertible note will come due (or convert to equity).
Over time as Convertible Notes have largely replaced priced rounds in the early stages of investment, there have been a few innovations to how startups use convertible debt as an instrument. The most popular has been the “SAFE Note” which stands for “Simple Agreement for Future Equity”. It’s still a convertible note, it just changes a few things, and that all helps the Founder.
A SAFE treats the capital invested not as equity in the company (yet!) or as debt. Think of it as an “IOU” for early investors that sits in stasis until a future equity event happens. If no conversion event happens, it’s actually possible for those holding convertible notes (as a SAFE) to wind up with no common stock at all.
Because there is no Debt component in a SAFE investment, the parameters of the convertible notes like an Interest Rate on invested capital or a Maturity Date when the note converts are removed. This puts more risk on investors not knowing if their investment will hit an event window (typically the maturity date) to guarantee a conversion.
The most important element of a SAFE for most early-stage investors is going to be the Valuation Cap (as we explained earlier) which indicates within the Convertible Note what the maximum valuation the investor will pay upon conversion. This is the same between a SAFE note and any kind of Convertible Note structure.
Funding, even with a convertible note, is a time-consuming process. While Convertible Notes have certainly sped up the time it takes to negotiate terms compared to an equity round or (gasp!) bank loans, that doesn’t change the fact that convertible noteholders are still investors — and they love to negotiate!
When entering the startup funding landscape and trying to wrap your head around everything, be patient. Startup funding is a critical component to your business venture and is a big issue to tackle. Even experienced entrepreneurs haven’t dealt with all the different types of capital in their careers. The key is understanding the different options available, and then very deliberately evaluating your options.
Continue to Part 1 of Phase Two of our Funding Series — "Investor Selection"